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.

Ratio Analysis


Related Articles
  1. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  2. Term

    Explaining the Declining Balance Method

    The declining balance method is a system for calculating an asset’s rate of depreciation against its non-depreciated balance.
  3. Investing

    How Rental Property Depreciation Works

    It's a bit tricky, but a valuable tool to make your investment pay off.
  4. Investing

    Understanding Accumulated Depreciation

    Depreciation is a rough approximation, in dollar terms, of the wear and tear on an asset. So the accumulated depreciation is the aggregate of the wear and tear on the asset from all prior time ...
  5. Forex Education

    Depreciation: Straight-Line Vs. Double-Declining Methods

    Appreciate the different methods used to describe how book value is "used up".
  6. Economics

    Double Declining Balance Depreciation Method

    The double declining balance depreciation method counts the depreciation of a long-lived asset’s book value at double the rate of its straight-line depreciation.
  7. Taxes

    Filling Out Form 4562: Investopedia Explains

    Step-by-step, how to fill out the depreciation and amortization form for your business tax return.
  8. Economics

    Understanding Carrying Value

    Carrying value is the value of an asset as listed on a company’s balance sheet. Carrying value is the same as book value.
  9. Forex Education

    Top Economic Factors That Depreciate The $US

    A variety of factors contribute to currency depreciation, including monetary policy, inflation, demand for currency, economic growth and export prices.
  10. Investing

    Depreciation

    Amortization and depreciation are two ways to prorate the cost of an asset's life. Learn more about the latter and how it it's calculated.
RELATED TERMS
  1. Depreciation

    1. A method of allocating the cost of a tangible asset over its ...
  2. Accumulated Depreciation

    The cumulative depreciation of an asset up to a single point ...
  3. Depreciable Property

    Any type of asset that is eligible for depreciation treatment. ...
  4. Accelerated Depreciation

    Any method of depreciation used for accounting or income tax ...
  5. Double Declining Balance Depreciation ...

    One of two common methods a business uses to account for the ...
  6. Bonus Depreciation

    An additional amount of deductible depreciation that is awarded ...
RELATED FAQS
  1. What is the relationship between accumulated depreciation and depreciation expense?

    Understand the relationship between accumulated depreciation and depreciation expense. Learn how each one is accounted for ... Read Answer >>
  2. How does accumulated depreciation affect net income?

    Learn why accumulated depreciation does not directly affect a company's net income; understand where a company accounts for ... Read Answer >>
  3. What is the tax impact of calculating depreciation?

    Understand the tax implications of a company's depreciation. Learn how differences in accounting methods change the amount ... Read Answer >>
  4. Is depreciation only used for tangible assets?

    Learn if tangible assets can be depreciated, as well as what other assets are eligible for depreciation so you can account ... Read Answer >>
  5. What would cause a decrease in accumulated depreciation?

    Understand what causes a decrease in a company's accumulated depreciation. Learn why a company's accumulated depreciation ... Read Answer >>
  6. What happens to accumulated depreciation when you sell an asset?

    Learn what happens to a company's accumulated depreciation when it sells an asset. Understand why accumulated depreciation ... Read Answer >>
Hot Definitions
  1. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  2. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  3. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  4. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  5. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  6. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
Trading Center