Compare Depreciation Methods and Learn Which to Use
Investing Lesson 4 - Analyzing an Income Statement
Now that we've covered most of the basic depreciation methods for calculating depreciation expense on the income statement and accumulated depreciation on the balance sheet, we need to have a discussion about comparing depreciation methods — the things that matter, the things that don't matter, and general observations about their various influences on reported profitability and shareholders' equity.
Depreciation Policies Don't Have Much Influence on Calculation of Intrinsic Value
You must understand that truly excellent businesses tend to be light on assets because their returns on capital are so high. There are still many good and great businesses that don't fall into this category but, all else equal, it's true. Depreciation policies aren't going to have much of an influence on the calculation of intrinsic value for a firm like Microsoft or Visa but they are going to be of the utmost important when analyzing Union Pacific or Alcoa.
Owner's Earning Calculation vs Earnings Per Share in Isolation
This is the reason that, personally, I prefer the use of an owner's earning calculation rather than looking at earnings per share in isolation. When you look at a business like Union Pacific through this light, you realize that real, economic profits are lower than the reported profits found at the bottom of the income statement.
Aside from that, there can be a lot of variation in the reported financial figures from year-to-year even when the underlying situation is identical. To make this point, let's review one of the depreciation examples we've been calculating thus far. Imagine you were examining a business that acquired an asset for $100,000.
This asset had a $10,000 estimated salvage value and you expected it to have a useful life of ten years. Despite economic reality being exactly the same in each case, here is the difference in the depreciation expense that would be charged to the income statement in each year depending upon the depreciation methodology managed opted to use in the preparation of its balance sheet and income statement.
Straight-Line Depreciation Method Appears to Be Less Profitable
You can see that despite nothing being different other than the accounting methodology, in, say, year nine, a company using the straight-line depreciation method is going to appear to be far less profitable than one using the sum of the years' digit or double declining balance depreciation method while, at the same time, having a much higher net worth resulting in a seemingly lower return on capital.
Another important thing to keep in mind is that some managements will report depreciation expense broken out as a separate line on the income statement, while others will be more clandestine about it, including it indirectly through SG&A expenses (for the depreciation costs of desks, for instance).
You'll also want to compare a company's depreciation practices to other firms in its sector or industry because some managements may be tempted to set unreasonably high estimated salvage values on assets, resulting in lower depreciation expense than peers.
Comparing Depreciation Methods
|Comparing Depreciation Methods|
|Method||Year 1||Year 2||Year 3|
|Sum of the Years||$2,400.00||$1,599.84||$800.16|
|Double Declining Balance||$3,200.00||$1,600.00||$0.00|