Depreciation

What Is Depreciation?

Depreciation is the process by which a company allocates an asset's cost over the duration of its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets - such as brands and intellectual property - this process of allocating costs over time is called amortization. For natural
resources - such as minerals, timber and oil reserves - it's called depletion.

Assumptions
Critical assumptions about expensing depreciation are left to the company's management. Management makes the call on the following things:

· Method and rate of depreciation
· Useful life of the asset
· Scrap value of the asset

Calculation Choices Depending on their own preferences, companies are free to choose from several methods to calculate the depreciation expense. To keep things simple, we'll summarize the two most common methods:

Straight-line method - This takes an estimated scrap value of the asset at the end of its life and subtracts it from its original cost. This result is then divided by management's estimate of the number of useful years of the asset. The company expenses the same amount of depreciation each year. Here is the formula for the straight-line method: Straight line depreciation = (original costs of asset – scrap value)/est'd asset life

Accelerated Methods - These methods write-off depreciation costs more quickly than the straight-line method. Generally, the purpose behind this is to minimize taxable income. A popular method is the 'double declining balance', which essentially doubles the rate of depreciation of the straight-line method: Double declining depreciation = 2 x straight line rate Double Declining Depreciation = 2 x (original costs of asset – scrap value / est'd asset life)

The Impact of Calculation Choices As an investor, you need to know how the choice of depreciation method affects an income statement and balance sheet in the short term. Here's an example. Let's say The Sherry Company purchased a new IT system for P2 million. Sherry estimates that the system has a scrap value of P500,000 and reckons it will last 15 years. According to the straight-line depreciation method, Tricky's depreciation expense in the first year after buying the IT system would be calculated as the following:
(P2,000,000 - P500,000)/15 = P100,000

According to the accelerated double-declining depreciation, Sherry's depreciation expense in the first year after buying the IT system would be this:

2 x straight line rate = 2 x(P2,000,000 - P500,000)/15 2 x straight line rate = P200,000

So, the numbers show that if Sherry uses the straight-line method, depreciation costs on the income statement will be significantly lower in the first years of the asset's life (P100,000 rather than the P200,000 rendered by the accelerated depreciation schedule). That means there is an impact on earnings. If Sherry is looking to cut costs and boost earnings per share, it will choose the straight-line method, which will boost its bottom line.

A lot of investors believe that book value, or net asset value, offers a fairly precise and unbiased valuation metric. But, again, be careful. Management's choice of depreciation method can also significantly impact book value: determining Tricky's net worth means deducting all external liabilities on the balance sheet from the total assets--after accounting for depreciation. As a result, since the value of net assets doesn't shrink as quickly, straight-line depreciation gives Sherry a bigger book value than the value a faster