- CFA Exams
- Level I 2020
- Study Session 8. Financial Reporting and Analysis (3)
- Reading 26. Long-lived Assets
- Subject 3. Depreciation Methods
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Subject 3. Depreciation Methods PDF Download
For accountants, depreciation is an allocation process, not a valuation process. It is important for analysts to differentiate between accounting depreciation and economic depreciation. Two factors affect the computation of depreciation: depreciable cost (acquisition cost - salvage or residual value) and estimated useful life (depreciable life). Note that it is depreciable cost, not acquisition cost, that is allocated over the useful life of an asset.
The different depreciation methods are:
- Straight Line Depreciation (SLD)
- Accelerated Depreciation Methods
- Profit margin is lower as net income is lower.
- Asset turnover ratio is higher as assets are lower.
- Debt-to-equity ratio is higher as equity is lower.
- Return on assets ratio is lower; both net income and total assets are lower, but net income is lower by a larger percentage.
- Return on equity ratio is lower; both net income and equity are lower, but net income is lower by a larger percentage.
- Units of Production (UOP) and Service Hours Method
- UOP = Depreciation [per period] = Output [per period] x Unit Cost
- Unit Cost = (Cost - Salvage Value)/Estimated Production Capacity or Estimated Service Life
Note that in the U.S. different depreciation methods have the same effect on taxes payable, as the depreciation method (MACRS) used for tax reporting is independent of the method chosen by management for financial reporting. It is taxes payable, not tax expense, that determines cash outlay for tax payment. Therefore, the choice of depreciation methods has no impact on the statement of cash flows.
Estimates Required for Depreciation Calculations
Depreciable life, also called useful life, is the total number of service units expected from a depreciable asset. It can be measured in terms of units expected to be produced, hours of service to be provided by the asset, or years the asset is expected to be used. The longer the depreciable life, the lower the annual depreciation expense.
Reducing the depreciable life of an asset has the following impact on financial statements over its depreciable life:
- Higher depreciation expense.
- Lower book value of the asset.
- Lower net income. The percentage effect on net income is usually greater than the effects on assets and shareholders' equity.
- Lower shareholders' equity (caused by lower retained earnings).
Consequently, a shorter depreciable life tends to reduce profit margin, returns on assets, and returns on equity, while raising asset turnovers and the debt-to-equity ratio. However, changing the depreciable life has no effect on cash flows, since depreciation is a non-cash charge.
Salvage value, also called residual value, is the estimated amount that will be received when an asset is sold or removed from service.
- The higher the salvage value, the lower the annual depreciation expense, as salvage value is deducted from the original cost to compute annual depreciation expense for depreciation methods such as straight-line, units-of-production, service-hour, and sum-of-the-years' digits.
- Salvage value serves as a floor for net book value for depreciation methods such as double-declining-balance, units-of-production, and service-hour depreciation.
- Note that MACRS assumes there is no salvage value.
The effects of choosing a lower salvage value are similar to those of a shorter depreciable life or an accelerated depreciation method. However, the effects do not reverse in the later years of the asset's useful life.
Shorter lives and lower salvage values are considered conservative in that they lead to higher depreciation expense. These factors interact with the depreciation method to determine the expense; for example, use of the straight-line method with short depreciation lives may result in depreciation expense similar to that obtained from the use of an accelerated method with longer lives.
Learning Outcome Statementsd. describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense;
e. describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios;
CFA® Level I Curriculum, 2020, Volume 3, Reading 26
User Contributed Comments 7
|benno||If you change the depreciable life, why no effect on CF's? Doesnt your depreciation tax shield increase during the reduced number of years (i.e increase CF?) Over the life of the asset the CF would be the same. Can someone explain?|
|yanpz||Because for tax purpose, as a rule, everybody use MACRS depreciation method. No matter what method you use for financial reporting purpose, CF won't change because tax won't change.|
|teddajr||1. Straight Line (SLD)
2. Accelerated Depn. (SYD and DDB)
3. Units of Production (UOP)
Tax reporting uses: Modiffied Accelerated Cost Recovery System
|meiko||There is no change in Cashflow, as depreciation is not a non-cash event.|
|mordja||Agree with yanpz and meiko.. but surely depreciable lives and salvage values are subject to discretion of management, thus different depreciation, thus different tax, thus differing CFO's.
This said, I appreciate that depreciation expense has no direct bearing on CF's.
|lavalyn||Differing depreciation, yes, and different income, yes. But everybody, for tax reporting, depreciates with MACRS, which may be different from financial reporting. So income is the same for tax reporting for depreciation regardless of management decisions.|
|robertdole||@benno - it's because its a non-cash item. The depreciation of the asset relates to net income (and lowers it). If we were to use the indirect method we would add back depreciation to arrive at CFO.|