Assumptions Play a Large Role in Depreciation Methods

A company can use depreciation methods to reduce taxable income, defer taxes to a later date or even show improvements in earnings or value. If you are not involved in accounting, you may be surprised to learn about the many simple changes in calculations that can result in largely different answers to the question of "what a company is worth." As a result, it is important to understand the assumptions an accountant is making in depreciation to properly assess the strength of the organization.

Depreciation Rate and Method

When a company purchases an expensive capital asset, it can capitalize the asset in its books. This adds the asset to the total assets of the company, and it reduces taxable income by allowing the company to subtract the amount of depreciation to the asset over its lifetime. Depreciation is defined as a loss in value. For many assets, the rate of depreciation is not consistent. For example, a new computer depreciates at a more rapid rate during the beginning of its lifetime than at the end of its lifetime.

To account for this, a company can use accelerated depreciation instead of straight line depreciation. By using accelerated depreciation models, the company knocks a bigger chunk of its asset base off the books in the years immediately following the asset's purchase than in later years. This not only affects taxable income, it also accounts for drastic shifts in return on asset models. The company itself gets to decide the rate of depreciation. As long as the asset has depreciated to the value of its scrap metal - i.e. the value of its components alone - by the end of its useful life, the company is following GAAP regulations.

Useful Life

A company is the only who determines the actual useful life of the asset. There is no "index" of useful life that is used for all similar assets. If a company you are investing in decides to say its truck will only last three years, it is permitted to do so as long as it accounts for depreciation completely in those three years. The return on assets for the company may be higher than the return on assets for a company that is depreciating the same truck over five years. This is a very easy way to shift a calculation.

Scrap Value of the Asset

The accounting professionals handling the asset's depreciation are the ones who ultimately decide what it is worth as "scrap metal." In the above example, one company could feel the truck is still worth $15,000 when it is no longer useful to the company, and another company may quote the value of only $5,000. The assets of the first company at the end of the truck's lifetime would appear $10,000 higher than the assets of the second company. This difference in value, however, is only true on paper. In reality, both companies are left with a truck they cannot use. As an investor, you may not always see the assumptions a company is making about the depreciation of the asset. To compensate for this problem, consider reviewing more than one model for assets, return on assets and profitability prior to making a decision.

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