Thursday, 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), divided by 10 years (useful life) yields an annual depreciation expense of $10,000. Unless the 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, you first 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%
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%
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 the residual 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 Units consumed
= ( 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 changes are applied to the depreciation schedule prospectively; that is, you simply readjust the 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 balance sheet 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.

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