Depreciation and Amortization Explained | 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 dive into the accounting principles for depreciation and amortization expenses. Let’s start with a quick refresher from our previous lesson on inventory expense recognition.
Period Costs and Depreciation and Amortization
Not all expenses can be directly tied to revenue generation, such as period costs (e.g., administrative costs and rent). These are expensed in the period incurred. Another type of expense commonly incurred is depreciation and amortization costs.
When a company acquires long-lived assets like equipment expected to provide future economic benefits beyond one accounting period, the cost to acquire the asset has to be accounted for. Depreciation is used for tangible assets, while amortization is used for intangible assets.
Calculating Depreciation and Amortization
So, how do we determine the amount to depreciate or amortize for each period?
- Straight-line method: Recognizes an equal amount of depreciation or amortization expense over the asset’s useful life. Requires estimating the residual value and useful life.
- Accelerated methods: Recognize more depreciation expense in the early years of the asset’s life. One common accelerated method is the double-declining balance method.
Accelerated methods like the double declining balance method are not used for amortization. For intangible assets with a finite life, the straight-line method is the most commonly used.
EXAMPLE
The shoe retailer recently purchased a delivery truck at a cost of $50,000. The truck is expected to be in use for the next 5 years, where it can reasonably be resold for $20,000. Calculate the depreciation expense for each year of the truck’s useful life using the straight-line method.
Using the straight-line method, we get an annual depreciation of $6,000 for the next 5 years. What if we use the double-declining balance method?
For the first year, we get a depreciation of $20,000. The net book value of the asset drops to $30,000. In the second year, the asset is supposed to be depreciated by $12,000. However, the residual value is $20,000, so the depreciation is limited to just $10,000 in the second year. Since the net book value has reached the residual value by the end of the second year, the depreciation expense is 0 for the remaining years.
Impairment and Subjectivity in Depreciation and Amortization
Intangible assets with indefinite lives, like goodwill, are not amortized but must be tested for impairment at least annually. If the asset value is impaired, an expense equal to the impairment amount is recognized.
When examining a company’s depreciation and amortization expense, an analyst should look out for areas of subjectivity, such as the method chosen for depreciation or estimating a higher than usual residual value. Both of these can result in higher current net income, which can be considered aggressive accounting.
That’s all for depreciation and amortization expenses! In our next lesson, we’ll explore non-recurring and non-operating items in the income statement.
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