Understanding Depreciation of PP&E | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll discuss depreciation of tangible assets, various depreciation methods, and their impact on financial statements. Get ready to learn about straight-line, accelerated, and units-of-production methods with examples.

Depreciation Basics

For tangible assets, the cost is initially capitalized and then systematically expensed over time through a process called depreciation. The historical cost, which includes the original purchase price, installation, and transportation costs, is the starting point for depreciation calculations.

Subtracting accumulated depreciation from the historical cost gives us the asset’s book value, also known as the carrying value. Although depreciation doesn’t involve cash expenditures, it is a real operating expense that should not be ignored.

Depreciation Methods

The CFA curriculum highlights three depreciation methods:

• Straight-line method
• Accelerated method
• Units-of-production method

Straight-Line Method

This method allocates an equal amount of depreciation expense over the asset’s useful life. To use it, we need to estimate the residual value and useful life of the asset.

Depreciation per year = (Historical cost – Residual value) / Useful life

Accelerated Method

For assets that generate more benefits in the early years of their economic life, accelerated depreciation is more appropriate. It recognizes more depreciation expense in the early years and less in the later years. One common accelerated method is the double-declining balance method.

Depreciation per period = (Net book value / Useful life) x 2

Units-of-Production Method

This method is based on usage rather than time, with depreciation expense proportional to the units produced during the period. In periods of high usage, the depreciation expense is also proportionally high.

Component Method

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Impact of Depreciation Method on Financial Statements and Ratios

The choice of depreciation method can have significant impacts on a company’s financial statements and ratios. Let’s examine these effects in more detail.

Income Statement

Using the straight-line method, the depreciation expense is lower in the initial periods compared to the accelerated method. Consequently, net income is higher in the initial years when using the straight-line method.

Balance Sheet

Under the straight-line method, accumulated depreciation is lower in the initial periods, leading to a higher net PP&E value on the balance sheet. This results in higher total assets, which in turn requires higher retained earnings to balance the accounting equation.

Statement of Cash Flows

As depreciation is a non-cash expense, the choice of depreciation method has no impact on cash flow. It is purely an accounting treatment.

Ratios

• Return on Assets (ROA): Since both net income and total assets are higher in the initial years when using the straight-line method, ROA is also higher.
• Return on Equity (ROE): ROE is higher in the initial years when using the straight-line method, as the percentage increase in net income is higher than the percentage increase in total equity.
• Asset Turnover Ratio: As revenue is unaffected by the depreciation method and total assets are higher when using the straight-line method, the asset turnover ratio is lower in this case.

Changes in Accounting Estimates

A change in depreciation method, such as from straight-line to accelerated, is considered a change in accounting estimate, rather than a change in accounting principle. This means that restating previous statements is not required. The company must disclose the change in the estimate and apply it going forward.

Other changes in accounting estimates include changes in salvage value and useful life of a long-lived asset. When making such changes, the firm needs to apply the change in book value and depreciation expense to the current period and prospectively to all future periods. The previous periods are not affected by the change.

For example, if a firm changes the salvage value and useful life of an asset, the depreciation expense going forward can be drastically altered, affecting the net income reported. Analysts should scrutinize such changes and determine if they are reasonable or if there is reason to suspect accounting manipulation.

Conclusion

This lesson has covered the impact of depreciation methods on financial statements and ratios, as well as the implications of changes in accounting estimates. In the next lesson, we will explore the amortization of intangible assets.