# Understanding Depreciation of PP&E | CFA Level I FSA

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

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.

EXAMPLE

A construction firm buys a tunnel-boring machine for \$500,000 with an estimated life of 4 years or 80km of distance bored and a salvage value of \$100,000. Assuming 20km usage in Year 1 and 15km each year for Years 2, 3, and 4, calculate the depreciation expense for Year 1 using the straight-line, double-declining balance, and units-of-production methods.

After working through the calculations, we get the following depreciation expenses for the first 4 years:

## Component Method

IFRS requires using the component method, which depreciates components of an asset separately.

Using the same example above, let’s assume a custom-made drill for the machine needs replacement at the end of Year 2, costing \$200,000. Using the straight-line method, calculate the depreciation expense when the drill is considered a separate component.

The total cost of the machine is \$500,000 at the beginning of Year 1, and the drill is \$200,000. The machine, less the drill, costs \$300,000 and is depreciated in 4 years to the salvage value of \$100,000. The initial drill has a useful life of 2 years and is depreciated to \$0 at the end of the second year. The replacement drill costs \$200,000 and is also depreciated to \$0 by the end of the fourth year.

Using the straight-line method for each component separately, we get the following depreciation amounts:

• Machine (less drill): \$50,000 per year for all 4 years
• Initial drill: \$100,000 per year for the first and second years
• Replacement drill: \$100,000 per year for the third and fourth years

Combined depreciation is \$150,000 for each of the 4 years.

Companies reporting under US GAAP may choose not to use the component method. In this case, the machine is considered as a whole, with a total cost of \$500,000 to be depreciated to \$100,000 in 4 years. The replacement drill, purchased at the beginning of the third year, is considered a separate capitalized asset with a \$200,000 cost to be depreciated to \$0 by the end of the fourth year.

Using the straight-line method again, we get the following depreciation amounts:

• Machine: \$100,000 per year for the first and second years
• Replacement drill: \$100,000 per year for the third and fourth years

Total depreciation is \$100,000 in Year 1 and Year 2, and \$200,000 in Years 3 and 4. Under both methods, the total depreciation is the same.

## 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.

## 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. See you there!

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