Depreciation and Financial Statements
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http://TheValueatRisk.blogspot.com November 5, 2009
Depreciation and Financial Statements The formal definition of depreciation is the systematic allocation of the cost of an asset, as an
expense, over a period of time. If I were able to provide a definition for depreciation, it would be
" a non-cash expense on the income statement, recorded in order to display the theoretical
consumption of an asset's useful life". Before I get started, it's important to understand the
distinction between depreciation recorded on a firm's financial statements, and the depreciation
expense used by a corporation to determine it's federal income tax liability. Basically, there are
two separate books that can show different depreciation expense for the same asset, in the
same year. The depreciation schedule that a corporation must follow on it's tax returns is known
as the Modified Accelerated Cost Recovery System (MACRS). If you want to read about
MACRS, you can refer to IRS Publication 946; I will be covering depreciation strictly from the
financial statement standpoint.
The two concepts you need to initially understand about depreciation are "Useful Life" and
"Residual Value". An asset's useful life is the period of time that the asset will provide an actual
economic benefit to the company; although an excavator could in theory still be alive after 50
years, the company might know from experience that an average excavator can only usefully
serve its purpose for 15 years; therefore, useful life = 15 years. Residual value is also called
salvage value, and its basically an estimate of what the asset could be sold for (as scrap
usually) after it has served the duration of it's useful life.
There are basically three accepted depreciation methods that corporations use to convey
information on financial statements: straight line, double declining balance, and units of
production. To determine the annual depreciation expense for an asset using the straight line
method, you simply plug your numbers into the following formula:
Annual Depreciation Expense = (Cost of Asset - Residual Value) / Useful Life.
Let's say a corporation purchases a truck for $110,000, estimates a $10,000 residual value and
10 years worth of useful life for the truck. A depreciable base of $100,000 (cost-residual value),
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firm ever determines that the truck's useful life or residual value has changed materially, this
$10,000/year will remain constant for each of the subsequent 10 years.
To determine the annual depreciation expense under the double declining balance method, youfirst need to determine the annual rate of depreciation by plugging your information into the
following formula:
Rate of Annual Depreciation = (100% / Useful Life) X 2
Using the same truck example from above, we'd calculate (100% / 10 years) X 2 = 20%. Step 2
involves plugging your depreciation rate into the following formula:
Year 1 Depreciation Expense = (Cost of Asset - Residual Value) X Annual Depreciation Rate
= ($110,000 - $10,000) X 20%
=$20,000
That $20,000 shows up as depreciation expense in Year 1 on the income statement, and also
appears in a contra asset account on the balance sheet known as "Accumulated Depreciation".The calculation for depreciation expense in Year 2 is as follows:
Year 2 Depreciation Expense = (Cost of Asset - Accumulated Depreciation - Residual Value) X
Depreciation Rate
=($110,000 - $20,000 - $10,000) X 20%
=$16,000
Once again, $16,000 flows to the income statement as an expense, and is added to
Accumulated Depreciation, resulting in a new balance of $36,000 at the end of Year 2. What
should be evident is that the double declining balance method results in a front-loading of an
asset's depreciation towards the beginning of it's useful life. By the end of the asset's useful life
however - in this case Year 10, both methods will have all of the asset's value except for theresidual value.
The units of production methods is, in my opinion at least, the most
effective/honest/straightforward method of depreciation. Unfortunately, it only works when the
asset has a useful life that can be represented in terms of a unit of measurement. For instance,
using the truck example again, let's say that the company estimates the truck will provide
200,000 miles worth of service. Operating off an identical depreciable base of $100,000, the
company could state that each mile amounts to 50 cents worth of depreciation for the truck.
Thus, if the trucks trip log showed 50,000 miles of service for the year, the formula for annual
depreciation using the units of production method is as follows:
Annual Depreciation Expense = ( Units of Useful Life / (Asset Cost - Residual) ) X Unitsconsumed
= ( 200,000 / ($110,000 - $10,000) ) X 50,000
= $25,000
The only other depreciation caveat to be aware of at this point is that sometimes management
adjusts it's estimates regarding the asset's useful life and salvage value. Luckily, these estimate
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schedule for the new variables based upon the already accumulated depreciation and original
cost.
Practically speaking, you can use your knowledge of the accumulated depreciation balancesheet account to gauge the relative age of the firm's long term operating assets. Simply divide
Accumulated Depreciation by the amount of long term assets to determine a depreciation
percentage. If your answer is in the 10-20% range, the firms assets are relatively new, and so
on. Older assets on the balance sheet could be a sign that the company will have to ramp up it's
capital expenditures in the coming years.Copyright 2009 ‐ The Value at Risk
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