What is Depreciation?

Definition:

A candy machine can lose value as it ages — Depreciation is how a candy-making business can account for that change in value over a specific period of time.

🤔 Understanding Depreciation

Not much lasts forever — so companies use “depreciation” as an accounting method to quantify that decline in value. Companies evaluate the lifetime they’ll use a physical asset for (picture any piece of heavy machinery), then distribute the expense of purchasing that asset over that time period in a couple different ways. FYI, “intangible” assets, like software, use “amortization” instead of depreciation, but it’s the same concept. The Internal Revenue Service (IRS) has some requirements for claiming your machine “depreciated." For example, you must use the asset in your day-to-day business, and it must have a quantifiable useful life that exceeds one year.

Example

UPS’ trucks deliver whatever it is you just ordered off the couch. The truck cost UPS $50K and can be sold at the end of its life in the future for $5K. Subtracting the purchase price ($50K) from the “salvage value” ($5K) means we can depreciate $45K. If the lifetime of the truck is 5 years (and UPS chooses to use "straight line depreciation”), this means UPS will decrease the value of the truck by $9K every year over 5 years.

Takeaway

Understanding a company’s depreciation method is like understanding a company’s language...

It allows you to read between the lines, helping you analyze the strength of a stock’s earnings. As you will see from below, different depreciation methods produce different outcomes.

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How do I calculate depreciation?

To calculate depreciation, you first need to determine the asset’s Modified Accelerated Cost Recovery System (MACRS) asset classification. The IRS provides tables detailing MACRS calculations. MACRS is straightforward when it comes to determining the useful life of a tangible asset, like a machine. The MACRS table covers all types of tangible assets. Most small-ticket business assets have a short useful life. Assets like computer equipment (5 years), office furniture (7 years), and farm equipment (7 years) fall into this category.

Big-ticket items have a useful life of 10 years or more. Items such as boats (10 years), roads and bridges (15 years), and multi-purpose farm structures (20 years) fall into this category. Real estate has an even longer useful life. Residential rental property such as single-family homes and apartment buildings have a useful life of 27.7 years. Commercial properties (such as an office or retail building) have a useful life of 30 years.

What is straight line depreciation?

While the IRS clearly defines useful life, there is greater leeway when selecting a depreciation method. The two most important types of depreciation to know are “straight line” and “double-declining balance” depreciation. But there are other types, including two other commonly-used accelerated depreciation methods, which allow companies to expense assets over a shorter time frame than the straight line method.

Straight line depreciation is simple to calculate and the most straightforward option you’ll probably come across. First, take the asset’s purchase price (how much it was bought for), then deduct the asset’s salvage value (the amount it’s likely to be sold for in the future, after it’s been used). Think of salvage value as the “scrap value” of an asset, like when you sell a car “as is” for a few hundred dollars at the end of its life.

For example, let’s say you have computer equipment purchased for $105K. The salvage value of the equipment is $5K. Subtracting salvage value leaves you with $100K to depreciate over the asset’s useful life. Using the straight line method, you expense an equal amount for each year of useful life. Since computer equipment has a MACRS useful life of 5 years, this means you would expense $20K each year for 5 years.

Companies use straight line depreciation for many reasons. For smaller companies, straight line is a simpler process. It requires less accounting work and is straightforward. Companies may also use straight line depreciation because it smooths out depreciation expense. This makes earnings more consistent, giving the impression of solid earnings performance. straight line can also overstate earnings. Especially for assets that wear out more quickly than their MACRS, their assessed useful life.

What is double-declining balance depreciation?

Other companies may consider more aggressive methods of depreciation. These accelerated methods allow companies to cut short-term taxable income so that they can pay fewer taxes. The primary accelerated depreciation calculation is double-declining balance depreciation. Double-declining balance method depreciation allocates an asset's cost sooner rather than later — So, you’re basically claiming it was more valuable upfront, than later on in its life.

Here's the breakdown of the double-declining balance method. Let's say you want to speed up the depreciation of the asset described above. For the first year, you would expense 40% of the $100K asset value (net of salvage value). This is double the depreciation expense we saw in the straight line method and reduces the asset’s “book value” (or value on the balance sheet) net of salvage value to $60K. In year two, you depreciate 40% of the current book value, or $24K. This reduces the asset’s book value to $36K. This method of depreciation “front-loads” allocation to the early years of useful life. While it reduces income in the short-term, it also helps minimize taxable income.

When analyzing a stock, it can be helpful to check if the company uses straight line or double-declining balance depreciation. Double-declining balance tends to understate earnings, especially if a company has recently made a large asset purchase.

For example, let’s say an airline recently upgraded its fleet of planes. If the airline uses accelerated depreciation, its short-term earnings could take a dip. But as the years progress, the depreciation expense decreases, improving profitability. Having less taxable income in the short-term tends to defer taxes to the future. When this is the case, it means more operating cash flow for the business in the present.

What are some other depreciation methods?

There are two other major depreciation methods. Sum of the years-digits, or “SYD” depreciation, is similar to double-declining balance. But it allows for a smoother allocation across the asset’s useful life. To determine depreciation using this method, you first need to calculate the asset’s SYD. SYD is the sum of years remaining on the asset’s useful life. For example, an asset with a 5-year useful life has an initial SYD of 1+2+3+4+5, or 15. Divide the remaining years of useful life by this number, and you have the depreciation percentage.

If we wanted to depreciate the computer equipment mentioned above using the SYD method, we would do the following calculation:

(Years of remaining useful life/SYD) x (Book value - Salvage value)

(5/(1+2+3+4+5)) x ($105K-$5K) = ~$33K.

Year two would be the remaining years of useful life (4), divided by 15, multiplied by the remaining book value (net of salvage value):

(4/15) x ($100K-$33K) = ~$18K

The second alternative method of accelerated depreciation is the unit of production method. This simpler method allocates depreciation on use rather than solely on age. The formula for unit of production is net asset cost divided by units produced.

For assets such as vehicles, mileage may be the best “unit of production.” Let’s say your business has a work vehicle with a purchase price (net of salvage value) of $50K. This particular vehicle typically can run 150K miles before conking out. In the first year, the odometer logs 37.5K miles, or 25%. This makes the first year's depreciation expense $12.5K.

How do companies depreciate real estate?

Real estate seems to always take a slightly alternative approach. Real estate is depreciated differently than other tangible assets, such as commercial vehicles, computer equipment, or industrial machinery — Key point: Real estate doesn’t have “scrap value.” Instead, you deduct the property’s land value from the purchase price before determining the depreciation amount. As you saw in the MACRS walk-through, you depreciate rental properties over 27.5 years, and commercial properties for over 30 years.

Another key difference regarding real estate is the appreciation factor. Most tangible assets lose value over their useful life. But company-owned real estate typically appreciates over time. Think of a manufacturer that owns its factory. The facility could have been purchased 30, 40, even 50 years ago. With inflation alone, the property may be worth more than its purchase price.

But the company cannot readjust its book value to market value. The factory is on the books at the purchase price, net of depreciation. And after decades of depreciation, the property’s “book value” could be zero.

This means many companies with significant real estate could have understated balance sheets. When assessing a stock’s intrinsic value, it can be helpful to consider these “hidden assets” in your calculation.

How do different depreciation methods affect earnings?

Understanding a company’s depreciation method is like understanding a company’s language. It allows you to read between the lines, helping you analyze the strength of a stock’s earnings. As you can see from above, different depreciation methods produce different outcomes.

For example, let’s say a company you were researching just bought a $10M computer system. The system has a scrap value of $2M. This means there is $8M of assets to be depreciated.

As you learned from Modified Accelerated Cost Recovery System (MACRS), you depreciate computer equipment over 5 years. Using the straight line method, this means in year one, the company recorded depreciation of $1.6M for the equipment:

$8 million/5 years = $1.6M

But if the company chose to use the double-declining method, depreciation charges would be higher:

$8M x 0.4 = $3.2M

How about sum-of-the-years method? Depreciation charges are less than double-declining balance but more than straight line depreciation:

(5/15) x $8M= ~$2.67M

As you can see, accelerated depreciation can understate a company’s true earnings. On the other hand, a company looking to boost quarterly earnings could start depreciating new assets using the straight line method. This could create the appearance of improved earnings. Different depreciation methods not only impact a company’s income statement — they can affect the balance sheet, too.

How does depreciation affect a company’s balance sheet?

Some assets lose their value super quickly (like your car), straight line depreciation can overstate book value. Accelerated depreciation provides a truer picture of book values. On the other hand, for assets that retain their value (such as real estate), accelerated depreciation can understate book value.

What does this mean? Investors need to do their homework when analyzing a stock’s financial strength. This is especially the case with companies that have too much debt. Overstating the book value of tangible assets can skew a stock’s debt-to-equity ratio. A capital-intensive business (think heavy industry) could appear to have a stronger capitalization structure. But if the company has to replace equipment sooner than depreciation implies, the company’s true financial picture could be worse than the books suggest.

What other metrics can I use to better understand a company’s earnings?

You always want to be adding more analysis tools to your investing toolbox. As you grow more comfortable with investing, you will learn more sophisticated earnings metrics. For example, there’s an earnings calculation called EBITDA. EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” This metric is best for assessing the operating performance of a business. By comparing a company’s EBITDA from one year to the next, you can see whether a company improved its earnings.

Sophisticated earnings metrics help you separate fact from “creative accounting.” But you don’t need to get too fancy — Just having a basic understanding of depreciation makes you a better analyst of stocks. Taking depreciation into account, can help you gain greater insight into a company’s financial performance. 20191129-1023937-3085420

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