While a company's financial reports – the income statement, the balance sheet, the cash flow statement, and the statement of owners' equity – represent the company's financial health and progress, they can't provide a perfectly accurate picture. There are always assumptions built into many of the items on these statements that, if changed, can have greater or lesser effects on the company's bottom line and/or apparent health. This article looks at how assumptions in depreciation impact the value of long-term assets and how this can affect short-term earnings results.

Salvage Values and Depreciation

One of the consequences of generally accepted accounting principles (GAAP) is that, while cash is used to pay for a long-lived asset, such as a semi-trailer to deliver goods, the expenditure is not listed as an expense against revenue at the time. Instead, the cost is placed as an asset onto the balance sheet and that value is steadily reduced over the useful lifetime of the asset. This reduction is an expense called depreciation. This happens because of the matching principle from GAAP, which says expenses are recorded in the same accounting period as the revenue that is earned as a result of those expenses.

For example, suppose the cost of a semi-trailer is $100,000 and the trailer is expected to last for 10 years. If the trailer is expected to be worth $10,000 at the end of that period (salvage value), $9,000 would be recorded as a depreciation expense for each of those 10 years – (cost - salvage value) ÷ number of years.

Note: This example uses the straight-line method of depreciation and not an accelerated depreciation method that records a larger depreciation expense during the earlier years and a smaller expense in later years. There are also two assumptions built into the depreciation amount: the expected lifetime and the salvage value.

Long-Term Assets

If you look at the long-term assets, such as property, plant, and equipment (PP&E), on a balance sheet, there are often two lines showing the cost value of those assets and how much depreciation has been charged against that value. (Sometimes, these are combined into a single line such as "PP&E net of depreciation.")

-- End Of Year Beginning Of Year Year-End Difference
Plant, Property & Equipment (PP&E) $3,600,000 $3,230,000 $360,000
Accumulated Depreciation (1,200,000) (1,050,000) ($150,000)

Figure 1

In the above example, $360,000 worth of PP&E was purchased during the year (which would show up under capital expenditures on the cash flow statement) and $150,000 of depreciation was charged (which would show up on the income statement). The difference between the end-of-year PP&E and the end-of-year accumulated depreciation is $2.4 million, which is the total book value of those assets. If the semi-trailer mentioned above had been on the books for three years by this point, then $9,000 of that $150,000 depreciation would have been due to the trailer, and the book value of the trailer at the end of the year would be $73,000. It does not matter if the trailer could be sold for $80,000 or $65,000 at this point (market value) – on the balance sheet, it is worth $73,000.

Suppose that trailer technology has changed significantly over the past three years and the company wants to upgrade its trailer to the improved version while selling its old one. There are three scenarios that can occur for that sale. First, the trailer can be sold for its book value of $73,000. In this case, the PP&E asset is reduced by $100,000 and the accumulated depreciation is increased by $27,000 to remove the trailer from the books. (The cash account balance will increase by the sale amount for all cases.)

The second scenario that could occur is that the company really wants the new trailer, and is willing to sell the old one for only $65,000. In this case, three things happen to the financial statements. The first two are the same as above to remove the trailer from the books. In addition, there is a loss of $8,000 recorded on the income statement because only $65,000 was received for the old trailer when its book value was $73,000.

The third scenario arises if the company finds an eager buyer willing to pay $80,000 for the old trailer. As you might expect, the same two balance sheet changes occur, but this time, a gain of $7,000 is recorded on the income statement to represent the difference between book and market values.

Suppose, however, that the company had been using an accelerated depreciation method, such as double-declining balance depreciation. (See Figure 2 below for the difference in depreciation between straight-line and double-declining depreciation on $100,000.) Under the double-declining balance method, the book value of the trailer after three years would be $51,200 and the gain on a sale at $80,000 would be $28,800, recorded on the income statement – quite a one-time boost! Under this accelerated method, there would have been higher expenses for those three years and, as a result, less net income. There would also be a lower net PP&E asset balance. This is just one example of how a change in depreciation can affect both the bottom line and the balance sheet.

The expected lifetime is another area where a change in depreciation will impact both the bottom line and the balance sheet. Suppose that the company is using the straight-line schedule originally described. After three years, the company changes the expected lifetime to a total of 15 years but keeps the salvage value the same. With a book value of $73,000 at this point (one does not go back and "correct" the depreciation applied so far when changing assumptions), there is $63,000 left to depreciate. This will be done over the next 12 years (15-year lifetime minus three years already). Using this new, longer time frame, depreciation will now be $5,250 per year, instead of the original $9,000. That boosts the income statement by $3,750 per year, all else being the same. It also keeps the asset portion of the balance sheet from declining as rapidly, because the book value remains higher. Both of these can make the company appear "better" with larger earnings and a stronger balance sheet.

Similar things occur if the salvage value assumption is changed, instead. Suppose that the company changes salvage value from $10,000 to $17,000 after three years, but keeps the original 10-year lifetime. With a book value of $73,000, there is now only $56,000 left to depreciate over seven years, or $8,000 per year. That boosts income by $1,000 while making the balance sheet stronger by the same amount each year.

Watch for Assumptions

Depreciation is the means by which an asset's book value is "used up" as it helps to generate revenue. In the case of our semi-trailer, such uses could be delivering goods to customers or transporting goods between warehouses and the manufacturing facility or retail outlets. All of these uses contribute to the revenue those goods generate when they are sold, so it makes sense that the trailer's value is charged a bit at a time against that revenue.

However, one can see that how much expense to charge is a function of the assumptions made about both its lifetime and what it might be worth at the end of that lifetime. Those assumptions affect both the net income and book value of the asset. Further, they have an impact on earnings if the asset is ever sold, either for a gain or a loss when compared to its book value.

While companies do not break down the book values or depreciation for investors to the level discussed here, the assumptions they use are often discussed in the footnotes to the financial statements. This is something investors might wish to be aware of. Furthermore, if a company routinely recognizes gains on sales of assets, especially if those have a material impact on total net income, the financial reports should be investigated more thoroughly. Management that routinely keeps book value consistently lower than market value might also be doing other types of manipulation over time to massage the company's results.