in one of the provided mock exams (A/MS/Case: Scott) there is a Q concerning the straight line vs MACRS depreciation method.
In the case a company switches from straight line (5 Y useable life) to MACRS (with 20% depreciation in the Y1). It asks whether the 1st year after-tax operating cash flow will most likely decrease, remain unchanged or increase!?!
Firstly, I reckoned does not change as it gives a 20% depreciation no matter which method is used in the 1Y! However, then I thought about the salvage value (which is present in this case) and that the salvage value is considered in deriving the annual depreciation expense using the straight line method, whereas it is disregarded in the MACRS method. This makes the annual depreciation differ and therefore gives different operating CFs in my opinion.
To my surprise, the answer is indeed “remains unchanged”. Can somebody please explain? Does it have to do with taxes?
Changing the depreciation method on the financial statements doesn’t change the pretax cash flow (depreciation is a noncash expense) and doesn’t change the after-tax cash flow (which depends on the depreciation method used for taxes, which hasn’t changed).
I think I remember this question from the schweser mock. The reason why it was “unchanged” is actually because the depreciation is actually the same amount under both MACRS AND straight-line. I calculated 20% of the beginning value in Y1 using the given MACRS rate and it’s the same as straight-line because the life of the asset was 5 years i.e.20% depreciation!
Asset $300,000; straight line depreciation over 5 years. Salvage value $20,000 after 5 years. MARCs for first year is 20%.
Accounting depreciation given in the question is $60k and the MARC depreciation is 20% ie $60k, hence no impact on net profit (and ulimately tax on the profit).