Your friend Xantha has just started a lawn mowing service and has purchased a group of new lawnmowers for $20 000. Xantha expects the mowers to last 5 years and to have zero residual value at that point. Xantha's business plan estimates that the business can cut 5000 lawns over the 5 years, with estimations of 500 lawns for year 1, 1000 for year 2, 1200 for year 3, 1800 for year 4 and 500 for year 5 over the 5 years.

Required:

a) Calculate the accumulated depreciation balance at the end of the second year using each of the following depreciation bases: a. Straight-line b. Reducing balance (25% rate) c. Units-of-production

b) Based on your calculations, which depreciation basis would produce the highest profits at the end of the second year?

c) Your friend Xantha has never heard of the unit-of-production basis. Explain why companies use it and comment on whether it would make sense for your friend's business

a)

• Accumulated depreciation using straight line method: $8,000
• Accumulated depreciation using reducing balance method: $8,750
• Accumulated depreciation using units of production method: $6,000

b)

Which depreciation basis would produce the highest profits at the end of the second year?

Reducing balance method

c)

Why companies use it and comment on whether it would make sense for your friend's business.

Using units of production method, depreciation can be calculated in accordance with the units the asset produced. By this, the depreciation is perfectly matched or allocated with the produced units. (See explanation below for more information)

Step-by-step explanation

a)

GIVEN:

Cost of asset = $20,000

Salvage value = 0

Useful life = 5 years

Total machine hour = 5,000 hours (500 + 1,000 + 1,200 + 1,800 + 500)

• Accumulated depreciation using straight line method:

To get the yearly depreciation using straight line method, here is the formula:

Annual depreciation = (cost of asset - salvage value) / useful life

Annual depreciation = ($20,000 - 0) / 5 years

Annual depreciation = $4,000

Since the depreciation must be 2 years, the annual depreciation must be doubled.

Accumulated depreciation for 2 years = annual depreciation x 2 years

Accumulated depreciation for 2 years = $4,000 x 2 years

Accumulated depreciation for 2 years = $8,000

• Accumulated depreciation using reducing balance method:

To get the yearly depreciation using reducing balance method, here is the formula:

Annual depreciation = write down from the value last year x depreciation rate

But for simplicity, I used table for computations:

After the 2nd year of depreciations, accumulated depreciation is equal to $8,750

• Accumulated depreciation using units of production method:

To get the yearly depreciation using reducing balance method, you need to get first the depreciation per machine hour and here is the formula:

Depreciation per machine hour = (cost of asset - salvage value) / total machine hour

Depreciation per machine hour = $20,000 / 5000 hours

Depreciation per machine hour = 4

Annual depreciation = units x depreciation per machine hour

For simplicity and to compute for the accumulated depreciation for 2 years, I used the table below:

After the 2nd year of depreciations, accumulated depreciation is equal to $6,000.

b)

By the three depreciation basis, both straight line method and unit of production methods has a depreciation expense of $4,000 in year 2. Using, reduction balance method, the only depreciation you will get at the end of year 2 is $3,750. Keep in mind that in computing net profits, depreciation expense is deducted from the revenue as it is an expense account. The lower the depreciation, the lower the amount you will deduct. And the lower the amount you will deduct, the higher the net income.

c)

Companies uses units of production as method of depreciating their assets or machine because it considers the process of producing the product instead of the time or its useful life. For example, the company produces higher units this year, the depreciation this year is higher compared to last year when using units of production method. Unlike with other depreciation method, even if you didn't produce units this year, you will still need to account depreciation expense since it is a fixed expense. In the case above, notice that depreciation expense in the first year is only $2,000 while the depreciation for the second year is $4,000. The depreciation in first year became doubled since the units produced also doubled in year two. It is only make sense that Xantha uses units of production method as the depreciation expense is properly allocated to her lawnmowers.

I hope that I helped you. If you have questions of clarifications, just comment them here so that I can further assist you. Have a nice day and good luck!