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 Internal Revenue Service (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 shown here for the company at December 31, 2012, for financial reporting purposes. Your concern relates to the accounting treatment of depreciation in light of the IRS Section 179 depreciation regulations displayed 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. 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: more than $480,000 (the $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 2013 and claim an expensing deduction then, assuming that you have sufficient business income.

Questions

Consider the 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?

2. How would you handle the depreciation deduction for income tax purposes?

3. How should the controller handle the matter, assuming that the financial reports have not been issued as yet, and that he reasons at stages 3, 4, and 5 in Kohlberg's model?