Discuss The Importance Of Depreciation Essays

Depreciation is a process of allocation and not valuation’. What do you think is meant by this statement?

rodrigo | August 22, 2016

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Introduction

The statement that depreciation is a process of allocation and not valuation is quite interesting and asserts a point of view that coincides with a specific type of depreciation.  The definition of allocation as well as valuation in their specific form is also of importance to distinguish the difference.  For example, straight-line depreciation is a cost allocation methodology that breaks the cost of an asset down into specific periods that does not establish any particular metric for valuation. Therefore, depreciation as process of allocation is a form of depreciating an asset that is indifferent to the underlying valuation with concern to the particular use of the asset and the specific period the asset is used.  Valuation will take into consideration the accelerated depreciation methodology that considers an asset as depreciating at a faster rate early in the useful cycle of the asset and slowing down to zero value with regard to depreciation of the asset as the asset approaches salvage value.

The meaning one attaches to depreciation is respective to the viewpoint one will have with regard to whether depreciation is a process of allocation or a process of valuation.  According to the ‘Accounting Review’, “”Depreciation” says one writer “means the consumption in production processes of a preliminary outlay in such [fixed tangible] assets as make production possible” but in the same article he says” “depreciation is to maintain the capital intact.” (Hatfield, 20, 1936) The older definition of depreciation is used as a means to assign what may be considered an ‘original’ or old economy meaning for depreciation that registers as accurate to businessman of earlier periods. The writer has purported a definition of depreciation that is specific to preserving capital in the form of an asset and is also specific to defining how to price ‘consumption’ by an asset during its useful production processes cycle.

I believe the statement of depreciation is a process of allocation and not valuation is stated with intent to mean that depreciation is a continuous and balanced process of an asset life cycle and until salvage. Therefore, the statement is intended to define the methodology of depreciation and detail how to depreciate an asset with respect to the underlying physical assets of a business.

References

Hatfield, HR 1936, ‘WHAT THEY SAY ABOUT DEPRECIATION’, Accounting Review, 11, 1, p. 18, Business Source Alumni Edition, EBSCOhost, viewed 5 December 2013.

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Tags: allocation and valuation, Depreciation

Category: Economics, Essay & Dissertation Samples, Finance

Be aware: companies work hard to make their fundamentals look good. So investors need to exercise judgment when examining numbers on financial statements. It's not enough to know simply whether a company has, say, great-looking earnings per share or low book value. Investors need to be aware of the assumptions and accounting methods that produce the figures.

Tutorial: Introduction To Fundamental Analysis

Here we look at how to achieve this awareness when analyzing depreciation, which can represent a big portion of the expenses found on a company's income statement, and which can impact the value of the investment opportunity in the short term. While there are rules governing how depreciation is expensed, there is still plenty of room for management to make creative accounting decisions that can mislead investors. It pays to examine depreciation closely.

What Is Depreciation?
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 of the 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. For intangible assets - such as brands and intellectual property - this process of allocating costs over time is called amortization. For natural resources - such as minerals, timber and oil reserves - it's called depletion. (For a background on reading financial statements check out What You Need To Know About Financial Statements.)

Assumptions
Critical assumptions about expensing depreciation are left to the company's management. Management makes the call on the following things:

  • Method and rate of depreciation
  • Useful life of the asset
  • Scrap value of the asset

Calculation Choices
Depending on their own preferences, companies are free to choose from several methods to calculate the depreciation expense. To keep things simple, we'll summarize the two most common methods:

  • Straight-line method - This takes an estimated scrap 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. Here is the formula for the straight-line method:

    Straight line depreciation = (original costs of asset – scrap value)/estimated asset life

  • Accelerated Methods - These methods write-off depreciation costs more quickly than the straight-line method. Generally, the purpose behind this is to minimize taxable income. A popular method is the 'double declining balance', which essentially doubles the rate of depreciation of the straight-line method:

    Double declining depreciation = 2 x straight line rate
    Double Declining Depreciation = 2 x (original costs of asset – scrap value / estimated asset life)

The Impact of Calculation Choices
As an investor, you need to know how the choice of depreciation method affects an income statement and balance sheet in the short term.

Here's an example. Let's say The Tricky Company purchased a new IT system for $2 million. Tricky estimates that the system has a scrap value of $500,000 and that it will last 15 years. According to the straight-line depreciation method, Tricky's depreciation expense in the first year after buying the IT system would be calculated as the following:

($2,000,000 - $500,000)/15 = $100,000

According to the accelerated double-declining depreciation, Tricky's depreciation expense in the first year after buying the IT system would be this:

2 x straight line rate = 2 x($2,000,000 - $500,000)/15
2 x straight line rate = $200,000

So, the numbers show that if Tricky uses the straight-line method, depreciation costs on the income statement will be significantly lower in the first years of the asset's life ($100,000 rather than the $200,000 rendered by the accelerated depreciation schedule).

That means there is an impact on earnings. If Tricky is looking to cut costs and boost earnings per share, it will choose the straight-line method, which will boost its bottom line.

A lot of investors believe that book value, or net asset value (NAV), offers a fairly precise and unbiased valuation metric. But, again, be careful. Management's choice of depreciation method can also significantly impact book value: determining Tricky's 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 Tricky a bigger book value than the value a faster rate would give. (Learn more about these methods of depreciation in Depreciation: Straight-Line Vs. Double-Declining.)

The Impact of Assumptions
Tricky chose a surprisingly long asset life for its IT system - 15 years. Information technology typically becomes obsolete quite quickly, so most companies depreciate information technology over a shorter period, say, five to eight years.

Then there's the issue of the scrap value that Tricky chose. It's hard to trust that a used, five-year-old system would fetch a quarter of its original value. But perhaps we can see the reason for Tricky's decision: the longer the useful life of an asset and the greater the scrap value, the less its depreciation will be over its life. And a lower depreciation raises reported earnings and boosts book value. Tricky's assumptions, while questionable, will improve the appearance of its fundamentals. (To move to the next level of analysis, check out our Advanced Financial Statement Analysis Tutorial.)

Conclusion
A closer look at depreciation should remind investors that improvements in earnings per share and book value can, in some cases, result from little more than strokes of the pen. Earnings and net asset value that are boosted thanks to the choice of depreciation assumptions have nothing to do with improved business performance, and, in turn, don't signal strong long-term fundamentals.

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