Case 2-4
Shifty Industries
Shifty Industries is a small business that sells home beauty products in the San Luis Obispo, California
area. The company has experienced a cash crunch and is unable to pay its bills on a timely basis. A great
deal of pressure exists to minimize cash outflows such as income tax payments to the IRS by interpreting
income tax regulations as liberally as possible. You are the tax accountant at the company and report to the
controller. You are concerned about the fact that the controller approved the Income Statement below for
the company at December 31, 2012 for financial reporting purposes. Your concern relates to the accounting
treatment of depreciation in light of IRS Section 179 depreciation regulations that are in Exhibit 1. The
depreciation relates to the purchase of one item of office machinery in 2012 for $40,000. The asset is
expected to have a five-year useful life with no salvage value and the company uses the straight-line
method of depreciation for all office machinery in its financial reports. You reviewed the income statement
to help prepare the income tax return for the company that will be filed on April 30, 2013.
Shifty Industries
Income Statement
For the Year Ended December 31, 2012
Sales Revenue:
Total Sales $137,460
Less: Sales Returns (2,060)
Sales Discounts (5,190)
Net Sales Revenue $130,210
Less: Cost of Goods Sold:
Beginning Inventory $ 12,300
Add: Purchases 67,310
Freight-In 4,450 $ 84,060
Less: Purchase Discounts (3,900)
Purchase Returns (1,000) (4,900)
Less: Ending Inventory (16,170)
Cost of Goods Sold 62,990
Gross Profit $67,220
Operating Expenses
Selling Expenses:
Freight-Out $ 6,150
Advertising Expense 5,790
Sales Commissions Expense 3,470
Administrative Expenses:
Office Salaries Expense 18,510
Office Rent Expense 14,000
Office Supplies Expense 5,330
Depreciation of Office Machinery 40,000
Total Operating Expenses (93,250)
Operating Loss $(26,030)
Other Incomes and Expenses:
Gains on Sale Equipment $2,430
Less: Loss on Sales of Investments (1,640)
Interest Expense (930) (2,570)
Net Other Incomes and Expenses (140)
Net Loss ($26,170)
A special rule known as “expensing” lets small businesses write off the entire cost of certain depreciable
assets in the year they are purchased.
In other words, you get to treat the cost as a business expense (hence “expensing”), such as salary paid or
utilities rather than an asset that has to be depreciated over a number of years. Property that qualifies for
this tax break includes machinery, tools, furniture, fixtures, computers, software and vehicles. (This special
rule often goes by the alias “the Section 179 deduction” to give homage to the section of the tax law that
allows it.)
This deduction is limited in several ways:
Dollar limit. For assets placed in service in 2012, you can take a maximum expensing deduction
of $500,000 —a higher-than-normal level approved by Congress to help the struggling economy.
Investment limit. As a way to focus this tax break on smaller businesses, firms whose investment
in new property exceeds a threshold amount gradually lose the right to expensing. For 2012, the
investment threshold is $2,000,000. For example, if you purchased $2,020,000 of otherwise
eligible equipment in 2012, you can’t expense more than $480,000 ($500,000 expensing maximum
minus the excess investment of $20,000).
Taxable income limit. Your total first-year expensing deduction cannot exceed your business’s
taxable income. Say, for example, that you bought $40,000 of property eligible for expensing in
2012, but your firm’s taxable income before taking expensing into account is just $20,000. That
means your expensing deduction is limited to $20,000; you can carry over the disallowed $20,000
to 2012 and claim an expensing deduction then, assuming you have sufficient business income.
Questions
Consider professional and ethical standards and ethical reasoning methods discussed in Chapters 1 and 2 in
answering the following questions.
1. Has the company properly handled the depreciation of the one item of machinery reflected on its
income statement for the year-ended December 31, 2012? Why or why not?
The company has not handled the depreciation of the machine correctly for financial reporting purposes.
The company policy for financial reporting is straight line depreciation. Thus, for financial reporting, the
2. How would you handle the depreciation deduction for income tax purposes?
The company should take $13,830 of depreciation (the $8,000 depreciation for financial reporting plus an
additional $5,830 of section 179 depreciation to bring income to zero) for 2012 and a carry forward of
3. How should the controller handle the matter, assuming the financial reports have not been issued
as yet, and that he reasons at stages 3, 4, and 5 in Kohlberg’s model?
The controller should make adjusting entries so that the depreciation expense is $8,000, which will result in
a net income of $5,830. However, in reasoning at stage 3, the tax accountant will want to satisfy the
controller and company’s interests. At stage 4, the controller is motivated by law and order considerations
Other considerations include that at stage 3, the tax accountant might be reluctant to go along with total
expense of the machine but may compromise to depreciation expense of $13,830 and net income of zero, to
match the tax depreciation. In reasoning at stage 4, the controller will want to follow the tax law, the IRS
regulations and the company policy on depreciation. He would argue for depreciation expense of $13,830