depreciation

I want to talk about subscription services and about cloud computing in particular.  This and the next couple of posts will lay some groundwork.

depreciation

As as investor, I’m interested in depreciation in the accounting sense–the expense on the income statement that represents the allocation of part of the cost of a capital asset (that is, an asset that lasts a long time, like a factory or a piece of machinery) against revenues in a given period of time.  (In an economic sense, which I’m not going to write about here, depreciation is the wearing out or obsolescence of a capital asset.  The two senses of depreciation aren’t the same thing.  In the accounting sense, for example, the laws in a given country or accounting convention determine what can be written off, and by how much.  A factory building, for instance, amy be allowed to be written off over 40 years.  At the end of that time, the carrying value on the balance sheet will be zero, or very close.  But the structure itself may be economically usable for another 20 years.  A further aside–this difference can be very pronounced when dealing with the depletion of mineral reserves.)

a non-cash charge

Depreciation doesn’t represent an outlay of cash during the period it is charged against income.  The factory is already built and the machinery is already installed before anything is made for sale.  It actually represents an inflow of cash which the company is not considering to be profit, but rather recovery of a portion of the capital investment it has made in plant and equipment.

figuring what the quarterly depreciation expense is

To determine the depreciation expense in a given accounting period, a company needs several pieces of information.  They are:

–the cost of the capital item

–its estimated useful life

–estimated salvage value, and

–the method to be used in allocating the depreciable cost (cost – salvage value) over the useful life.

Two allied concepts to depreciation are amortization and depletion. Depletion is the cost allocation procedure for the value of mineral reserves;  amortization is the procedure for intangible assets.

depreciation methods

straight line

The most commonly used method of depreciation in financial reporting is straight line. This means that the depreciable cost is spread in equal amounts over the estimated useful life.  Let’s assume, for example, that an asset has a cost of 1,000, a useful life of 10 years and a salvage value of zero.  The the depreciable value is 1000 – 0 = 1000.  1000/10 years = 100/year.  This means depreciation expense of 25 per quarter or 100 per year.

accelerated

Sometimes companies feel that assets, like computer systems, lose value faster than the straight-line method allows for.  So they will voluntarily use a depreciation method that writes off a larger amount of the asset’s cost in the earlier years of its life.  More often, governments will give companies a tax break by allowing them to use an accelerated depreciation method for writing off a given type of investment on the company’s tax return.

two accelerated techniques

There are two main methods of accelerating depreciation.  They may not make a lot of intuitive sense, but since they’re mostly intended as tax breaks, that shouldn’t matter too much.

1)  declining balance

Declining balance is the name for a family of depreciation schemes that key off the straight line depreciation method.  Specific declining balance schemes are designated as, say, 2x declining balance, 1.75x declining balance, etc.  The number in front refers to the multiple of straight line depreciation that’s applied each year to the depreciable balance for the asset.  “Declining balance” refers to the fact that the the gross depreciable amount declines.  It is reduced each year by the value of the prior year’s depreciation, before the new depreciation is calculated.

For example, let’s say we’re going to use double (2x) declining balance to depreciate the above ten-year life asset with original cost of 1000 and no salvage value.  For a ten-year life asset, straight line depreciation is 10% of the value each year.  Using 2x declining balance means using two times the straight line percentage, or 20%, as the percent of the asset value that we’ll depreciate in each year.

In year one, this means our depreciation is 20% of 1000, or 200.  For year two, we first subtract last year’s depreciation from asset value; that is, 1000 – 200 = 800.  Second year depreciation is 20% of 800, or 160.  In year three, the depreciable balance is 800 – 160 = 640.  Depreciation is 20% of 640, or 128.  And so on.

One quirk–the declining balance method can never get the asset fully depreciated, because you’re always taking only a fraction of the depreciable balance each year.   So accountants made up a fudge to get the system to work.  At some point, declining balance gets you a smaller depreciation expense than using straight line would.    In our case it’s at year six (where 2x declining balance = 20% of the depreciable balance; straight line = 25%).  At that point, you switch to using straight line for the remaining years.

3) sum of the years digits

This method, which doesn’t have any rationale that I can see, is nevertheless pretty straightforward.  Take the estimated useful life in years.  Add together all the digits from one through that number.  That gets you the denominator of a fraction.  Assign the highest digit of the series to the first year of depreciation, the next highest to year two, etc.  That get’s you the numerator.  For each year, multiplying  (the gross depreciable amount) x (the digit assigned) /(sum of the digits) = that year’s depreciation.

For example, in our ten-year lived asset, the sum of the digits 1-10 is 55.  Therefore, first year depreciation is 1000 x 10 /55 =   181.82.  Second year depreciation is 1000 x 9 /55 =  163.64.  And so on.

Two points:

–depreciation is a key element in the calculation of cash low, which is the topic of the next post in this series, and

–the difference in between the taxes on profits as shown in a given financial report to shareholders and the (often much lower) amount actually paid to the tax authority gives rise to deferred taxes, which can be a key element of cash flow as well.

More about these topics in the post on cash flow.

5 responses

  1. I will just add to this great piece above, that depreciation charge and expense are two different items. From the financial statements of a manufacturing company, depreciation expense is not mentioned, but depreciation charged to items manufactured during the period is provided.
    Depreciation for the entire period is charged to good produced during the period. All the costs (including depreciation charged) of goods produced during the period are added to the costs (including depreciation) of goods available for sale at the start of the period. This total is costs of goods available for sale during the period. Less the costs (including depreciation) of goods available at the end of the period, gives you the costs of goods sold.
    Dep exp would then be dep in the starting inventory, plus the dep charged to goods produced during the period, less the dep in the costs of goods sold. The first and third items are not required to be provided in the financial statements, hence dep expense during the period is an unknown item.

    • Thanks for your comment. You bring up several important points.
      1. The best place to find depreciation expense is not on the income statement but in the flow of funds statement. As you observe, for a manufacturing company depreciation that is associated directly with making individual products may simply be mixed in with other operating expenses and not broken out separately. Even in the flow of funds statement, it may be lumped in with amortization. For what I want to talk about a couple of posts from now–cash flow per share vs. earnings per share as ways to measure value–this last doesn’t make any difference, however.

      2. Depending on accounting and reporting conventions in a given country, you may only be able to find a reliable number in the annual statements. In some areas, you may have to dig into the footnotes.

      3. Depreciation is not an outlay of cash during the period it appears in the financials. Rather, it is a non-cash allocation of the cost of capital equipment used in company operations. During the period it appears as a cost, it actually represents an inflow of cash to the company. I’ve added this point to the post.

      4. When a product is placed in inventory, the carrying value includes not only the direct cash costs of making it but also an element of depreciation (and also some overhead). Inventory may be written down in value if the company determines it is impaired and cannot be sold at a profit, but it’s not usually depreciated.

      5. Depreciation is almost always a period cost. That is to say, it is charged against income and allocated across all items manufactured no matter whether the firm makes a few of them or a lot. So per unit depreciation may vary from period to period. There is one exception that I can think of, though. It’s called “units of production” depreciation. It normally occurs with minerals extraction companies. With other companies it’s a sign of big trouble looming ahead, in my experience.

  2. I recently investigated depreciation on my blog turnaroundinvesting.com.

    In the article I basically argue that due to the recession, and the accounting rules set up for impairment charges, moving forward depreciation is likely to run LOWER than maintenance capex. Basically depreciation is now lower than economic reality at some manufacturing companies.

    The link is here, I know I need to work on how I title my articles so the link isn’t so brutal.

    http://turnaroundinvesting.com/2011/01/22/on-valuing-companies-after-a-recession-how-traditional-graham-and-dodd-literature-needs-to-be-revised-and-traditional-basedown-case-earnings-power-modeling-needs-to-be-adjusted/

    • Thanks for your comment. I’ve read your post. It’s really interesting. If I understand correctly, you’re saying that during the recession some managements wrote down their fixed assets to substantially below fair market value. As business improves, this will mean profits and returns will look better than they should be. Also, maintenance capex will likely exceed depreciation. Both characteristics will make the firms look healthier–and growthier–than they actually are.
      It’s hard to know without citing specific companies, but I wonder whether some company assets aren’t at least as impaired as writedowns make them seem. You might argue that writedowns are just catching up with reality in the markets the company is in, or that the assets are the best of a prior generation but are now obsolete, or that Chinese firms have both labor and capital cost advantages, or some other thing… I’m not saying this is correct. I’m just curious. Is the evidence that clear?

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