From cars and lawnmowers to televisions and cellular phones we understand that the items we purchase are never going to be worth more than the moment we buy them. This is known as depreciation, which simply means something we bought today has less value, in dollar terms, five years later.
Companies experience depreciation when they purchase certain tangible assets that are needed to grow their business. However, for a company, particularly one that is publicly traded, how they account for that expense can be very different. As an investor, it's important to understand depreciation as it relates to a company's financial statements.
In this article, we’ll define depreciation, review the components that businesses will use to calculate depreciation, give example using different methods for calculating depreciation and list the metrics of a company’s financial statement that can be affected by the way depreciation is calculated.
What is depreciation?
Depreciation is an accounting practice that allows a company to record, as an expense, only a portion of an asset’s cost over the period of that asset’s useful life. This expense is recorded on a company’s financial statement as a liability. The benefit for a company in recording a depreciated asset is that, by spreading the cost of an asset across several years, it can help them show a higher net asset value (NAV) that many investors see as a key to assigning a proper valuation to a company.
Depreciation is used for tangible assets such as machinery, buildings, and equipment that a company needs for its operations and sees as producing future benefits. Sometimes a company has intangible assets, such as intellectual property or a brand, which carry with them an expense they wish to spread out over time. This is called amortization. When a company is looking to do the same for natural resources (i.e. oil reserves, etc.) it is called depletion. While amortization and depletion are similar to depreciation, they are different enough that we will focus our attention in this article on the topic of depreciation.
What are the components that factor into depreciation?
In order for a company to calculate depreciation, and decide which type of calculation to use, they must first determine the rate of depreciation. This is done by considering three data points. One is a known cost and the other two are variables.
- Original cost of the asset– this is the known cost. It is simply the price, in dollars, that the company paid for the asset. If they bought a bulldozer, on sale, for $90,000, that is the cost they use to calculate depreciation. They do not factor in the retail value. It is the cost of the asset to them.
- Useful life of the asset– this is the number of years that a company plans to use this asset. A piece of heavy equipment may have a useful life of 10 years or more. Whereas new computers, or software, may have a much shorter useful life. However, this is considered a variable because a business can assign any value they wish.
- Scrap value of the asset– this is the dollar value of the asset at the end of its useful life. It is called a variable because a company is free to assign any value they wish.
How to calculate the annual rate of depreciation
While there are different methods that a company can use to record depreciation, they are all based on the rate of depreciation for an asset. The calculation for this is known as the straight-line method and it is based on the components we just explained.
(Original cost – Scrap value)/Useful life of the asset
Let’s take the bulldozer we referenced above and create an example:
Company ABC has purchased a bulldozer for $90,000. They are estimating it will have a useful life of 10 years and are additionally estimating that its scrap value would be $30,000.
The annual rate of depreciation would be:
(90,000 – 30,000)/10 =
60,000/10 = 6,000
So if Company ABC chose to use the straight-line method to record this depreciation they would list a $6,000 expense every fiscal year for the next 10 years. The company may choose this option if the expense will have a significant impact on their bottom line. But as we’ll describe now, there are other methods that a company can use to record depreciation.
What methods can be used to calculate depreciation?
In addition to the straight-line method shown above, there are other methods that a company can use. Many use the straight-line method as a baseline for their calculations.
Capitalized depreciation– If a company uses this method, it will never depreciate the asset.
Expensed depreciation– If a company uses this method, it will fully depreciate the asset in the first year.
Accelerated depreciation– in this model, the greatest deductions for depreciation occur within the first five years. There are three commonly used formulas that calculate accelerated depreciation. All are based on the straight-line method.
- Double Declining Balance Depreciation (DDB) – this method simply takes the straight line method formula and multiplies it by two. The equation looks like this:
((Original cost – salvage value)/number of useful years) x 2
Using our example of the bulldozer from above if the annual rate of depreciation for the straight-line method was $6,000, it would be $12,000 in the first year using the DDB method. This calculates to be approximately 13%. In the second year, it will deduct the $12,000 from the original cost and multiply that number by the same percentage to get the depreciation.
Year Two – 90,000 – 12,000 = 78,000 x 13% = $10,140
The company would continue to use this formula until the depreciation value becomes lower than the $6,000 it would have been using the straight-line method. At that point, they would simply use the $6,000 value for their depreciation.
- 150% Declining Balance Depreciation – this method is similar to the DDB method, but takes 150% of the usable life of the asset as the basis for its calculation.
Using our example, a 10-year service life divided by 150% would come out to be a 15% per year rate of depreciation off of the remaining principal value. Since the usable life was already factored into the calculation for the 150% value, it is not needed anymore.
Year One: 90,000-30,000 x 15% = $9,000
In year two, the calculation would start by deducting 9,000 from the book value.
Year Two: 60,000 – 9,000 = 51,000
51,000 x 150% = $7,650
Like the DDB method, once the depreciation value was less than the value of the straight-line method, the depreciation would convert to the straight-line method.
- Sum of the Years Digits Depreciation – this formula reduces the percentage of the depreciation value based on the number of years remaining in its usable life. This allows the first few years to show a higher depreciation value than the remaining years. It’s the principle behind the idea that a car loses a high percentage of its value as soon as you drive it off the lot.
The formula requires a calculation of the percent depreciation value per year. This is calculated by dividing the number of years of remaining asset life by the sum of the asset life every year until the usable life is done. The first number in the formula will decline by one every year. The second number will stay constant. The sum of the depreciation percentages should add up to 100% at the end of the time period being used.
Using our 10-year example, that would look like this (note for the purposes of this example, the depreciation percentages are rounded).
|
Year
|
Formula
|
Depreciation Percentage(approx.)
|
|
One
|
10 (years remaining)/55 (sum of all years)
|
18%
|
|
Two
|
9/55
|
16%
|
|
Three
|
8/55
|
15%
|
|
Four
|
7/55
|
13%
|
|
Five
|
6/55
|
11%
|
|
Six
|
5/55
|
9%
|
|
Seven
|
4/55
|
7%
|
|
Eight
|
3/55
|
5%
|
|
Nine
|
2/55
|
3.5%
|
|
Ten
|
1/55
|
2%
|
Why will a company choose one depreciation method over another?
The choice of which method a company will use to calculate depreciation comes down to the objective they are trying to achieve. A company that chooses to use the straight-line depreciation method is probably more concerned about keeping its book value higher. This method will help keep their revenue numbers higher and give their earnings per share (EPS) a lift.
On the other hand, a company may be looking to decrease its taxable income. In this case, they may choose an accelerated depreciation method that will allow them to lower their income and provide tax savings.
How depreciation impacts a company’s financial statement.
It makes sense that the way a company calculates its depreciation will have an effect on certain aspects of its financial statement. These are some of the common areas that will be affected.
- Net Income – Depreciation will even out the variability of a company’s reported income because the cost of a major expense will be divided between many years. This means that depreciation will allow a company to show higher profitability at the beginning of the depreciation period.
- Stockholders’ equity – Over the length of the depreciation period, the effect may not be significant, but at the beginning, shareholder equity will be higher than it would be without the depreciation.
- Cash flow from operations – Depreciation will be on cash flow from an investment.
- Reported assets – When a major expense is shown as depreciated over time, the total assets of the company will be higher.
- Financial ratios – A company will show a higher profitability ratio at the beginning of the depreciation period. Equity turnover will be higher, but operation-efficiency will be lower.
Depreciation and fundamental analysis
One of the metrics that investors use to gauge a company's financial health is its net asset value (NAV). One reason for that is that it is perceived to be straightforward and free from bias. However, depreciation and the method used to calculate it can affect a company's net asset value (NAV) particularly if the straight-line method is used as opposed to using an accelerated method.
The other caution for investors is that the depreciation method is only as good as the assumptions that they are based on. If a company overestimates the useful life of an asset, it can have a significant impact on their NAV. In the same way, if the company overestimates the salvage cost of the asset the formula is skewed.
Although most publicly traded companies will abide by the Generally Accepted Accounting Principles (GAAP), depreciation is a gray area that allows a company to make assumptions that may improve fundamentals in a way that has nothing to do with the performance of the business.
The bottom line on depreciation
Depreciation is an accepted accounting practice that allows companies to allocate the cost of an asset over the expected useful life of the asset. Depreciation can help a company sustain a net asset value (NAV) and also can provide a lift to their earnings per share which are key metrics that investors will scrutinize during earnings season.
The three components that will determine the depreciation value of an asset are the original cost of the asset, the scrap value of the asset, and the projected useful life of the asset. The original cost is a known cost, the remaining two costs are variables – meaning a company can assign a value that may or may not be accurate.
The straight-line method is the most common way to calculate depreciation. This is done by dividing the value of the asset (original value – scrap value) by the useful life of the asset. In some cases a company may choose to use an accelerated depreciation model, the three most common are:
- Double Declining Balance Depreciation Method
- 150% Declining Balance Depreciation
- Sum of the Years Digit Depreciation
Each one uses the components of the straight-line method in some form to come up with the new value.
Depreciation can affect a company’s financial statements. Sometimes improved NAV may be the result of the juggling of numbers more than strong business fundamentals. As investors perform fundamental analysis of a company it’s important that they understand the assumptions that a company is making if they are depreciating the cost of an asset.
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