Question

The manager of a hotel has the permission of the owner to have a new swimming pool built. The manager contacts three companies for bids to do this construction work. The highest bidder has told the manager that if his bid is accepted he will also install a swimming pool at the manager's house at a 25% discount. The manager agrees to accept this offer and justifies the decision by believing that the higher swimming pool cost to the hotel will provide a larger depreciation expense amount. This, in turn, will reduce the income tax that the hotel has to pay and therefore provide the hotel with more working capital.

Instructions

It is a given that accepting a kick-back in the form of a 25% discount for a swimming pool at the manager's house is not very ethical, so unless you just want to vent, there is no need to discuss this point further. For this discussion, what is the flaw in the manager's justification that the higher swimming pool cost to the hotel will provide a higher depreciation expense amount which, in turn, will result in a benefit for the owner?

Answer 1

Not only his act is unethical rather his justification is also not correct.

we will explain this with examples. Let us consider the lowest bid for the work was of 100$ and the highest bid was of 150$, now he has accepted the highest bid so we will analyze whether it is beneficial for hotel to go for higher bid

	for example all value are in $
	Depreciation straight line for 5 years
	Year 1	Year 2	Year 3	Year 4	Year 5
100	20	20	20	20	20
150	30	30	30	30	30
Difference	10	10	10	10	10
Tax benefit assuming 30% tax on income	3	3	3	3	3
total tax benefit in 5 year	15	which will further low if we consider the net present value of future tax savings
Initial extra investment	50

Therefore we can see that It is always beneficial to incurred the less initial cost rather than thinking of tax benefit due to higher depreciation expense, it is only provide benefit when expense is inflated without incurring the actual expense to avoid the right tax calculation and payment.