How Depreciation Methods Could Affect Investors' Decisions in Investing
How Depreciation Methods Could Affect Investors' Decisions in Investing
When looking at the different methods of depreciation an investor need to take caution when looking at the numbers on a financial statement. Just because the companies have good earnings per share or low book value there is different accounting methods used to produce the figures. We will focus on depreciation methods and how it can affect the income statement of a company.
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 ofthe 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.
Management of the company makes decisions on the depreciation, the method and rate of depreciation and the useful life of the asset. There are a few different methods for depreciation expense. Let's go over the two most common methods, Straight-line method and Double declining depreciation.
The Straight-line method takes a depreciation 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. The formula of the straight-line method looks like this: Straight line depreciation = (original costs of asset depreciation value)/estimated asset life.
The double declining depreciation method write-off depreciation costs more quickly than the straight-line method. The purpose behind this method is to minimize the taxable income. This method basically doubles the rate of depreciation of the straight-line method. The double declining depreciation formula looks like this: Double Declining Depreciation = 2 x (original costs of asset depreciation value / estimated asset life asset life).
What does it mean by choosing one of the methods? The depreciation methodaffects an income statement and balance sheet in the short term. Let's look at the two methods with an example firm. Joe's Hotdogs buys a new fryer for his fries for $2,000. Joe's Hotdogs estimates that the system has a depreciation expense value of $500 and it will last about 15 years. According to the straight-line method, Joe's depreciation expense in the first year after buying the new fryer would be calculated as follows:
($2,000 - $500)/30 = $50
Using the double declining method:
2(($2,000 -$500)/30) = $100
So, the numbers show that if Joe's Hotdogs uses the straight-line method, depreciation costs on the income statement will be significantly lower in the first years of the asset's life ($50 rather than the $100 rendered by the double declining depreciation schedule).
Looking at the two numbers there is an impact on earnings. If Joe's Hotdogs was looking to cut costs and boost earnings per share, it will choose the straight-line method, which would boost its bottom line.
Most investors look at the net asset value which some think would offer an unbiased and precise metric. Joe's Hotdogs 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 Joe's Hotdogs a bigger book value than the value a faster rate would give.
Things to look at that can make Joe's Hotdogs depreciation methods questionable. First off taking a long life of the fryer of 30 years, fryers could break down or replace before that I would say that a reasonable life of a fryer should be about 15 -20 years. The depreciation expense value is a little high. It would be hard to believe they could fetch a value of a fryer for $500 after using it for 10 years. Let's look at the reasons why Joe's Hotdogs would use these values and method. The longer the useful life of an asset and the greater the depreciation expense value, the less its depreciation will be over its life. Lower depreciation raises reported earnings and net worth. Joe's Hotdogs inputted values for depreciation will improve the appearance of its fundamentals.
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