Understanding Depreciation and Amortization
Source: financial-education.com
Depreciation can be a component of both cost of sales (depreciation on manufacturing equipment) and selling, general, and administrative expenses (depreciation on sales offices). Depreciation is the allocation of the cost of assets that are expected to provide benefits over more than one accounting period.
For example, a company purchases a $450,000 piece of equipment that is expected to have a useful life of four years and a salvage value of $50,000 at the end of that time. It would not be appropriate to record the entire $450,000 (or even $400,000) as an expense on the income statement in the first year because the equipment will be used to generate revenues over its useful life of four years. Therefore, the cost of the equipment should be allocated over its useful life of four years. This allocation process is termed depreciation in the case of tangible assets such as equipment, amortization in the case of intangible assets, and depletion in the case of natural resources.
Because it would be costly to have the equipment appraised each year to determine its “depreciation” in value, and the resulting figure would still be subjective, estimation techniques are used. There are two basic types of estimation techniques, “straight-line” and “accelerated.”
Straight Line Depreciation
The most common estimation method for financial reporting purposes is the straight-line method. In using this method, the cost of the asset (less any salvage value) is divided by its useful life. This amount is then depreciated, or shown as used up, each period. For our example, the straight-line depreciation expense would be $100,000 per year ((450,000-50,000)/4). The total expense of $400,000 is thus spread evenly (in a straight line) over the useful life of the machine.
Accelerated Depreciation
While straight-line depreciation results in the same depreciation charge in each of the asset’s useful years, accelerated methods show more depreciation in the early years of an asset’s life. These methods reflect the fact that some assets wear out (depreciate) more quickly in the early years. Mathematical techniques to calculate accelerated depreciation include the sum-of-the-years’-digits (SYD) method and the declining balance (DB) method.
In the SYD method, the percentage applied to calculate annual depreciation begins at a higher rate than straight-line but decreases over time. Under the SYD method, the digits of each of the years of the equipment’s life are summed to create the denominator of a fraction, the numerator of which declines each year, beginning with the number of years in the asset’s life. In our example, a company purchases a $450,000 piece of equipment that is expected to have a useful life of four years and a salvage value of $50,000 at the end of that time. Using SYD the denominator would be calculated as 1+2+3+4=10. Depreciation in year 1 would be 4/10 of $400,000, or $160,000; in year 2 it would be 3/10, and so on. The total depreciation expense for the four-year period is $400,000, just as it was under the straight line method. The sole difference is manifested in the allocation of depreciation among the years.
In the DB method, the percentage applied is also higher than straight-line but remains constant as it is applied to the declining balance of the asset. In the DB method, the first step is to determine the straight-line rate of depreciation (1/Useful Life), which in this example is 25%. This rate is then multiplied by an acceleration factor (usually 150%, 175%, or 200%) to get the accelerated rate. Using an acceleration factor of 150% would result in an accelerated rate of 37.5%. Under this method, 37.5% of the asset’s net book value (cost minus accumulated depreciation) is depreciated each year. Depreciation for the first year would be 37.5% of $450,000, or $168,750. Year 2’s depreciation would still be computed using the 37.5%, but that rate would now be multiplied by ($450,000 – $168,750). Unlike the previous two methods, salvage value is not incorporated directly in the computation. Instead, we simply stop depreciating the asset when the net book value equals the salvage value.
In the final year, depreciation is adjusted to the amount needed to reduce the carrying value to the estimated salvage value. Again, note that the total depreciation over the life of the asset remains $400,000.
Final Note:
Comparing two different companies is always like comparing Apples and Oranges. They may different in the way of accounting depreciation. Even if they use the same style, the number of years they take to spread over will be different. Generally in sectors like automobiles etc, where machinery are used exhaustively, more depreciation cost will be accounted. Also in accelerated depreciation, as the depreciated amount decreases over time, comparing 2 years report of the same company becomes difficult. Nothing wrong in each company choosing its own style of accounting. But whenever any accounting principle changes, particularly in terms of depreciation, it should be an alert call for you. Similarly, Increase in Good will component should also raise an alert. It does not mean that the company is trying to hide things from you, but it definitely means you need to do more research.
