On January 1, Year 1, Golden Company purchased a new computer system for $50,000. Management estimates that the system will have a 5-year life and a salvage value of $7,500. Jane Golden, the company president, knows that the system can be depreciated using either the straight-line method or the double-declining-balance method. She is concerned as to the possible effect on various financial statement analyses if the company uses one method versus the other.Required: a) Indicate which method will have the larger negative effect (in other words, the less favorable effect) on each of the following ratios in Year 1: (1) Debt-to-equity ratio (2) Return-on-sales b) Indicate which method will have the larger negative effect on each of the following ratios in Year 4: (1) Debt-to-equity
ratio (2) Return-on-sales
What will be an ideal response?
| a) | (1) Double-declining balance method |
| b) | (1) Straight-line method |
Double-declining-balance depreciation recognizes greater depreciation expense in an asset's early life and less expense in later years. That means that in Year 1, double-declining depreciation will result in lower stockholders' equity, thus a higher (less favorable) debt-to-equity ratio and lower (less favorable) return on sales. This will reverse itself in Year 4.
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What will be an ideal response?