The Impact on Current and Future Profit of a Number of Costs and in General - Research Paper Example

 Financial Management Final Table of Contents Cover page ……………………………………………………………………………………………….1 This page………………………………………………………………………………………………….2 Executive Summary ……………………………………………………………………………………3 Introduction………… …………………………………………………………………………………4 Discussion……………… ……………………………………………………………………………….4 1. What will be the impact on current and future profit of a number of costs? …………...……….4 2. In general what should be the guide in the determination …………………………...……………4 of an acquisition cost is capitalized or expensed? ………………………………….………...……4 3. Complete Exhibit 1 of the case……………………………………………………………..…………4 4. Complete Exhibit 2 of the case……………………………………………………………..…………5 5. Under two disposal options prepare the journal entries for each alternative and make recommendation. ….………………………………………………………….…6 Conclusion………………………………………………………………………………………………...7 Appendices -- Exhibits .…………………………………………………………………………………9 References…………………………………………………………………………………………….....10 Executive Summary This paper has found that the impact of a number of costs on current and future profits will depend on whether they should be expensed or capitalized at present. Capitalizing cost is generally favorable to the company as it would defer cost and would increase net income under accrual accounting in the earlier years. Capitalizing cost can affect the cash flows because of the depreciation method used. Depreciation methods vary one could be favorable or unfavorable to a company for tax purposes. But since Delta is required to use MACRS method for tax purposes, where higher depreciation expenses are reported at the earlier years than the latter years, the same must be followed. This would have the effect of saving the company from taxes because of lower income during early years when compared using a straight line method of depreciation. However the management of Delta has other purpose for its accounting information. Since it uses the same to reward managers like Driscoll, the decision of what method will definitely affect cash flows of the company. Since this paper is taken from the point of view of manager Driscoll, who happens to have an influence on the choice of depreciation method, that which is more favorable to him will be chosen by him. Between the straight line and double declining balance, higher expenses in 2005 would be reported under the latter method thus Driscoll would rather choose the straight-line method. Thus, a conflict on the interest of Delta is evident on the use of methods, while the accelerated method of depreciation is favorable to Delta for tax purposes; it is unfavorable to the company for bonus purposes of its managers. To settle the conflict so as not discourage managers, a policy should be made clear on what method should be used for bonus purposes. Moreover operation managers like Driscoll should not have an influence on how cost are reported and computed so that the information may not be altered to suit personal preferences. Introduction This paper seeks to discuss the impact on current and future profit of a number of costs and in general which should guide the determination of whether an acquisition cost is capitalized or expensed. In addition computations are required to complete Exhibits 1, 2 and 3 as given in the case study. 1. What will be the impact on current and future profit of a number of costs? The impact on current and future profit of a number of costs will depend when cost are recognized for purposes of computing profit under the accrual method of accounting. If cost is capitalized now, it would have the effect of deferring at present the recognition of expenses. From a management point of view, the manager would look better to owners assuming the manager is not the owner. This is the reason why Driscoll is rewarded with bonus based on the company’s earnings before interest and taxes. Less cost means more profit when costs are capitalized in the meantime. However for taxation purposes, the higher the income in the current period because of less expenses brought about by the capitalization, the higher would be the net income tax of the business and it would be disadvantageous for cash flow purposes. In terms of cash flows it would be more disadvantageous to pay higher taxes at the earlier period than at the latter period. Fortunately, for Delta Cargo, it was required use the MACRS as depreciation method and this would make expenses high at earlier years and low at latter years. From a financial concept standpoint, it is more favorable to Delta Cargo. 2. In general what should be the guide in the determination of an acquisition cost is capitalized or expensed? In general the guide in the determination of an acquisition cost is capitalized or expensed is the existing accounting standards provided by standard setters and compliance with these standards are required by regulatory agencies in the preparation of financial statements. Under the US, they have the generally accepted accounting standards (GAAP) but under the other parts of the world they have the international accounting standards (IAS) or the international financial reporting standards (IFRS). Standards are meant to make financial information submitted by the companies to the public objective and reliable. The two standards have great similarities. For the purpose of this paper and this issue, the elements of cost on acquisition and what need to be expensed and capitalized are both within the coverage of those standards. Under accounting standards, the elements of the cost for the purpose of recording the acquisition cost of Plant Property or Equipment would include the purchase price, the cost attributable to bringing the asset to the location and condition necessary for it to be capable of operating in a manner intended by management, and initial estimate of the cost of eventually dismantling and removing the asset.1 (Wiecek and Young, 2009). 3. Complete Exhibit 1 of the case assuming Driscoll agrees to incur all $2.288 million in costs to acquire the crane. Completion of Exhibit 1 is found in Appendix A. As can be seen in Appendix A, all of the costs are capitalized based on the requirement of existing accounting standards as discussed earlier. The costs of shipping, handling, and assembling, additional in-house assembly cost, operator training, consultant operator, severance for forklift operators, support beams for dock, special paint work and Delta Cargo stencil, are all part of directly attributable cost to brining the asset to the location and condition necessary for it to be capable of operating in a manner intended by management 4. Complete Exhibit 2 of the case, using total depreciable costs as determined above. What factors should guide Driscoll’s final determination of depreciation expense? Completion of Exhibit 2 is found in Appendix B. That which gives lower depreciation in 2005 is more favorable to Driscoll. For bonus purposes, the straight-method should be preferred over the double declining balance method. As a manager who would benefit from the choice of method, Driscoll would choose what is favorable to him. However from the point of the Delta as organization, that which will effectively reflect the performance of manager should be adopted. For the purpose of this paper, there appears to be indication on the case that there is a policy on what method should be used. 5. Driscoll is considering two options for disposing of the old forklifts; prepare the journal entries for each alternative and make recommendation. The journal entry for disposing of the old forklift under the first option – see without refurbishment, would be as follows: The journal entry for disposing of the old forklift under the second option - with refurbishment would be as follows: Note that under the second option the refurbishment cost of $60,000 for the 10 units of forklift was capitalized hence it increased the Machinery and Equipment Account but it do not affect the accumulated depreciation and the amount of loss. 6. What impact, if any above analysis on Driscoll’s potential bonus? The impact if any of the above analysis on Driscoll’s potential bonus is to either increase or decrease the same depending on the basis of the bonus. It appears that the basis of the bonus is on net profit before interest and taxes. Hence what needs to be done is the relation of each of the option in the analysis. Anything that would increase the base as basis of bonus, the same should be favorable to Driscoll’s potential bonus. On the other hand, anything that would decrease the base as basis of bonus, the same should be unfavorable to Driscoll’s potential bonus. As to the choice of depreciation method, straight line is better for Driscoll over other methods. See Appendix C for Completed Exhibit 3. However, as the disposal options, the loss on sale of assets is the same for both options. For practical purpose, however, why have it refurbished for months if there is no added profit from doing so? 7. Other important considerations Case facts provide that using the crane would allow replacement of the forklifts and improve efficiency and speed. Moreover it is provided that new technologies on the market rendered the forklifts obsolete. Thus, the decision to acquire the crane as replacement of the forklift is a decision that must be made and the issue should go how much savings from the choice would be generated. Since the case facts do not provide how much would be saved from the use of crane, the same could be computed from the incremental revenue that could come because of the new technology.2 By using the time value of money, cash flow for the life of the crane or 10 years must be estimated and discounted using a cost of capital.3 The values would then be compare with the cost of investment and if there is net present value generate at positive amount, by all means the decision acquire is acceptable and more advantageous to the company. Conclusion This paper concludes that Driscoll just needed to be objective in the use of data for purposes of deciding whether the crane should be purchased. Since the case facts provide that the crane acquisition was very important to the company since it will the first to use the technology and that it would give the competitive advantage to Delta, it can only be assumed that is acquisition to replace the forklifts should push through. The issue on the impact on current and future profit of a number of costs would point to better option of having cost as capitalized rather than expensed for cash flow purposes. The issue of what should be the guide in the determination of an acquisition cost is capitalized or expensed is settled by the fact that there are requirements like the accounting standards and tax laws that must be obeyed and management has no liberty to just choose any. In case of rewarding managers however, the issue becomes internal to the company and which would help it attain its objectives. Management should however be correct in its decision for doing so as choosing the wrong or short-sighted method may work against its interest. Moreover, the bonus of Driscoll will actually become an issue to the paper since he has a stake on how much he would receive as compensation based on earnings. Since manager’s bonus is based on earnings before interest and taxes, it would mean that company is using accrual accounting to reward performance which may actually disregard the time value of money. The choice of depreciation methods is important therefore in determining the bonus since the depreciation could be high or low depending on the method. The MACRS or the double declining balance would give higher depreciation expenses during earlier years and if the revenues of Delta are assumed to be more or less contact, more depreciation means low earnings before interest and taxes and lower bonus for Driscoll on early years. The issue of what is acceptable in for book use and tax purposes would become immaterial if the company is compelled to use a method like MACRS, which is basically declining and therefore higher expenses at the earlier years. This is more advantageous to Delta since lower taxes at earlier years could actually represent saving in taxes which it could use for other business purposes. This case is however a capital budgeting decision which must involve the use of cash flows and discount rates over the life of the project. The savings could not be readily computed as well because of the lack of information on how much could be saved from operating cost in case the forklifts are replaced. Neither was it possible to estimate the incremental revenues that would have come from the acquisition of the crane. Appendix A- Exhibit 1 as completed Appendix B - Exhibit 2 as completed Appendix C – Exhibit 3 References: Brigham, E. and Houston, J. (2002). Fundamentals of Financial Management. Thomson South-Western Case Study - Lewis Driscoll and Delta Cargo Wiecek and M. Young. IFRS Primer International GAAP Basics. John Wiley and Sons, 2009, page 94 Read More