Assets - Depreciation
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
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 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 Methods
Changes in depreciation methods can be done in three ways:
- Change the depreciation method for all newly acquired assets.
- Change the depreciation method for current and all new assets.
- Change in depreciable life or salvage value.
Changing the Depreciation Method for All Newly Acquired Assets
The 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 Assets
This 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.
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 Value
A 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.
Financial AdvisorsObtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
Financial AdvisorsLearn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
ProfessionalsLearn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
ProfessionalsFind out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
ProfessionalsChapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
ProfessionalsThe Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
ProfessionalsBecoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
Options & FuturesWe decode the meaning of the many letters that can follow the names of financial professionals.
ProfessionalsPrepare to ace the CFA Level 1 exam by studying systematically.
Personal FinanceMany advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A professional designation given by the CFA Institute (formerly ...
A financial professional who studies various industries and companies, ...
The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>