Question

Effects of depreciation on income and cash flows In its financial statements, Flysafe Airlines has for many years depreciated its aircraft over an estimated useful life of 12 years. In preparing this year's financial statements, management decided to revise the estimate from 12 years to 15. Briefly explain how this revision in estimated life is likely to affect this year's: (a) Net income. (b) Net cash flow. (c) Taxable income.

Answer 1

Long-lived asset like equipment, machinery etc. undergoes wear & tear throughout its useful life due to operations. Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset's value has been used up. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits. The depreciation expense is a non-cash expense as no cash flows are associated with it.

Answer with explanation:

a) Net Income
Normally depreciation is charged every year in the income statement as an expense. It is an adjusting entry made to be in conformity with the matching concept of accounting. Depreciation is the step by step writing off of the value of the asset. When the life time of the asset revised from 12 to 15, the rate of depreciation will decrease, which will in turn reduce the depreciation expense to be charged to income statement. For instance, if the cost of the aircraft is $600,000 with 12 years estimated useful life, the depreciation rate under straight line method will be 8.33% (100 × 1/ useful life). When the useful life is revised to 15 years, the depreciation rate will be reduced to 6.67%. Thus irrespective of the method of depreciation used, there will be a decrease in the amount of depreciation expense when the useful life of the asset is increased. Hence, the depreciation expense for the current year onwards will decrease, which means increase in Net Income.

b) Net Cash flow

As for the cash flow there is no change in the current period. Depreciation is a methodical allocation of the cost of an asset (planes in this case) to the expense account over the years of its useful life (15 in this situation), and thus it is a non-cash charge to the income and has no effect on the cash flow, means there is no cash inflow or outflow. The only time there is a change in cash flow in relation to the tangible assets, is when either there is a new purchase or a sale.

c) Taxable income

If no changes are made in the length of the useful life of the asset or the method used when preparing a federal income tax, there is no change in the taxable income.