Understanding accounting for depreciation
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You must always bear in mind that even the best of companies try very hard to present their financial statements in the best possible light and will undertake anything within the law to achieve this objective. So you should not take numbers on any financial statement at face value and blindly use these numbers to crunch your ratios. If you do not understand the basis on which these numbers are generated, you could end up producing some great looking price-earnings ratios for instance and act on this analysis.
Depreciation is often a major item on the expense side of any financial statement and can have a substantial impact on the value of your investment. Understanding depreciation accounting and principles is a good way to start looking at the impact of accounting policies that produce the numbers on the financial statements. Depreciation is the process by which a company writes off or charges off the cost of an asset over its useful life. Every year, when its financial statements are prepared, a portion of its investment in fixed assets such as buildings of plants and machinery is charged as an expense to reflect the wear and tear caused by usage.
When this process is used for writing off tangible assets, it is called depreciation. In the case of intangible assets such as patents or other intellectual property, it is called amortisation and, in the case of natural resources such as crude oil reserves, it is called depletion. Though there are generally accepted sets of rules about depreciation, there is still scope for plenty of creative accounting which is why you must understand the process thoroughly.
In general terms, the management of the company has the right to make the following choices about the depreciation policy that they will follow:
- The method of depreciation and the rate that will be applied
- The scrap value of the asset and
- The useful life of the asset
There are several methods that are available to calculate depreciation and the two most commonly used methods are:
- The straight-line method in which the scrap value is deducted from the cost of the asset and then divided by the useful life to calculate the yearly depreciation charge. It should be noted that the same amount is charged every year to expenses
- The accelerated depreciation methods write-off the cost of the asset in a shorter period of time than straight-line depreciation. This is often employed to reduce taxable income and a popular accelerated method is known as “double declining balance” in which the straight-line depreciation charge is doubled
Let us now examine the impact of these varying depreciation methods on the bottom-line of the company. It is assumed that the company purchases a new computer hardware system for $1 million. The scrap value is estimated at $200,000 and the useful life at 10 years. Under the straight-line depreciation method, the charge would be calculated by subtracting $200,000 from $1 million and dividing by 10. This will give a yearly depreciation charge of $80,000. If the double declining balance method is used, the depreciation charge will be double or $160,000. The first method will therefore yield a higher figure for earnings than the second method. Naturally a company looking to boost its EPS would opt for straight-line depreciation.
Many investment experts point to book value or earnings per share as reasonably objective valuation methods for a company. However, the depreciation policy that is selected can substantially influenced this ratio and both book value and earnings per share can be manipulated by the choice of the depreciation policy. A change in depreciation policy can trigger changes in these ratios would without any change in the underlying fundamentals of the business.
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