Depreciation

CFA Level 1 - Assets

Depreciation Methods

Identification of depreciation methods:

• Straight-line depreciation
• Per unit of production
• Per hour of service
• Declining balance
• Sinking-fund depreciation

The only depreciation method that was not previously explained is the sinking-fund depreciation. The sinking-fund depreciation is rarely used and is prohibited in the U.S. and some other countries. Under this depreciation method, the amount of depreciation increases every year to maintain a fixed internal rate of return (IRR).

Formula 8.6


Depreciation in year i =
CF in year i - (IRR * book value at beginning of the year)

CF is defined as the cash derived every year from a particular asset.

Effect of depreciation on financial statements, ratios and taxes:

• Straight-line depreciation - This method will create a steady income stream, tax expense and ratios. Return on assets will increase over time if the equipment continues to generate the same products and price per unit remains constant.
• Per unit of production and per hour of service - These depreciation methods produce a variable depreciation expense. Net income will vary but it could be more reflective of production-to-cost (matching principle). One of the drawbacks of this method is that if units of products decrease (slowing demand for the product), depreciation expense also decreases, resulting in an overstatement of reported income and asset value.
• Declining balance - Income will be lower in the first years. As a result taxes will be lower and CFO will be higher. If production and selling prices of goods remain constant, ROA will be much higher in later years.
• Sinking-fund depreciation - The only benefit of this method is that the income reported should reflect ROI earned by assets.

Depreciable LifeDepreciable life, whether it is defined by years of useful life or by production units, is the most significant estimate that must be made in the determination of the depreciation expense.

The estimated salvage value of an asset is also important but not as significant. The role of depreciable life and salvage value is important because it is an estimation given by management. As such, management can use this estimation choice to manipulate current and future earnings.

The most common form of manipulation is an overstatement in the write-down of assets during a restructuring process, which will be reported as an extraordinary item and will result in the inflation of future net profits.

Changing Depreciation MethodsChanges in depreciation methods can be done in three ways:

1. Change the depreciation method for all newly acquired assets.
2. Change the depreciation method for current and all new assets.
3. Change in depreciable life or salvage value.

Changing the Depreciation Method for All Newly Acquired AssetsThe change in depreciation method will only affect future acquired assets. As a result, no past adjustment need to be made; the only thing that will change is future depreciation expense.

That said, the change in depreciation expense will be gradual, and the change in ratios will also be gradual.

Change the Depreciation Method for Current and All New AssetsThis is a much more complex change and will require all past assets to be restated to reflect the new depreciation accounting method. For all new assets it's not really a problem, but for the past assets the cumulative effect of the changes on past income statements must be reported (net of tax) on the current income statement. Furthermore, these changes must be included in net income from continuing operations.

Example of effect:Say a company changes its depreciation method, the straight-line method, to one that would have previously created a larger depreciation expense, the double-declining method).

This will cause past expenses to be higher and income to be lower. At the time of recognition, net income from continuing operations will decrease. Future depreciation expense will decrease (they would have already been expensed) but will increase in future years once all of the old assets are replaced.

Look Out! ROE and ROA will decrease even though assets and equity will decrease; the larger impact will come from a large decrease in net income.

Change in Depreciable Life or Salvage ValueA change in depreciable life and/or salvage value is not considered an acting policy change; it is a change in estimate. As a result, a company is not required to restate it in financial statements. The only thing that will change is the current and future net income.

For example, if an asset's life is shortened, this will increase the company's current and future depreciation expense, and decrease net income, ROA and ROE.

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