Portfolio Management - Depreciation

Depreciation is also an important consideration for which the devil is in the details and the details are in the footnotes. Depreciation is defined as the allocation of the cost of an asset over a period of time for accounting and tax purposes. Essentially, it means accounting for wear and tear, obsolescence or just the passing of time.

GAAP permits several accounting treatments of depreciation, and any company issuing publicly traded securities must declare in footnotes which treatment it uses.

Let's say a manufacturing company buys a production plant for $10,000,000 and expects it to last for 20 years. The effect on the balance sheet on that day is that $10,000,000 in current assets - cash - goes away and $10,000,000 appears in the asset class called Property, Plant and Equipment. Nothing happens on the income statement.

  • Straight-line Depreciation
    • At least, nothing happens there on Day One. Each year for the next 20 years, a portion of that $10,000,000 capital outlay will hit the income statement as Depreciation Expense.

    • The next question is, "How much depreciation expense will the company report after the first year?" The easy answer is $500,000 - that is, $10,000,000 divided by 20 years.

    • That is called straight-line depreciation, and it is the most conservative treatment available and the one least likely to bring about scrutiny from auditors and regulators. Still, it does not always reflect the economic reality of the life of that asset.

  • Modified Accelerated Depreciation
    • If you have If you were depreciating the car straight-line, you would expect its residual value to be $16,000 ($20,000 minus the first of five $4,000 annual depreciation expenses).

    • Not a chance! It is now a used car and it does not matter how often you washed it, waxed it and had the oil changed. The market for vehicles is such that your car might have lost almost half its value the day you drove it off the lot.

    • That is why GAAP also allows modified accelerated depreciation, which can more accurately reflect this economic reality.

    • Modified accelerated depreciation assumes the amount of capital used up is not a constant year-over-year. There are several modified accelerated depreciation models, but the most likely to be mentioned by name on the exam is modified accelerated cost recovery system(MACRS).

    • You will not need to know how to compute MACRS on the Series 7 exam.

Why Use Accelerated Depreciation?
One reason a company likes to use accelerated depreciation is that it is a higher expense that offsets revenue in the near term, depressing the company's earnings and, thus, its tax burden.

This is especially attractive because there is no actual cash involved: the capital outlay has already occurred - otherwise, the asset being depreciated would not be there. If next year you could have either a $1,000,000 tax shield or a $500,000 tax shield and it would not cost you a dime more either way, which would you choose?

Regardless of the depreciation treatment used, the amount of depreciation expense recorded on the income statement is also added to the Accumulated Depreciation line on the balance sheet.

Depreciation relates to physical assets. Natural resources - copper in a mine or oil in a well, for example - also get used up and are accounted for by an analogous treatment called depletion. Intangible assets, such as patents or trademarks, are subject to amortization.

The decision companies make regarding depreciation can affect the bottom line in various ways, learn how within the article Appreciating Depreciation.

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