What is Depreciation?
Depreciation is an expense that reduces the value of a fixed asset (PP&E) based on a useful life and salvage value assumption.
On the income statement, depreciation is recorded as a non-cash expense that is treated as a non-cash add back on the cash flow statement. On the balance sheet, the depreciation expense reduces the book value of a company’s property, plant and equipment (PP&E) over its estimated useful life.
How to Calculate Depreciation (Step-by-Step)
In theory, this is a more accurate representation of the operational performance of the company, since the capital expenditure required to purchase the fixed asset is recognized across time span wherein it is generating revenue.
The concept of depreciation is an important consideration in order to understand the true cash flow profile of a company since it is a non-cash expense and can often be affected by discretionary assumptions by the company (i.e. determining the useful life).
- Non-Cash Expense: Depreciation is added back on the cash flow statement (CFS) as it is a non-cash expense – this means that there was no actual cash outflow despite depreciation being classified as an expense on the income statement and reducing earnings.
- Tax Shield: While depreciation is treated as a non-cash expense and added back on the cash flow statement, the expense reduces the tax burden for the period since it is tax-deductible.
- Net Income: The recognition of depreciation on the income statement results in some “noise” when evaluating the net income as recorded on the income statement and is why the cash flow statement is also necessary to evaluate a company’s performance.
Depreciation: Operating Expense on Income Statement?
As such, the recognition of depreciation on the income statement reduces taxable income, which leads to lower net income (i.e., the “bottom line”).
It is rather uncommon for companies to report depreciation as a separate expense on their income statement. Thus, the cash flow statement (CFS) and footnotes are recommended financial filings to obtain the value of a company’s depreciation expense.
IRS Topic No. 704
IRS Topic No. 704 (Source: IRS)
The depreciation expense is scheduled over the number of years corresponding to the useful life of the respective asset.
- Depreciation Expense: The depreciation expense represents the allocation of the one-time capital expenditure cash outflow throughout the useful life of the fixed asset – in an effort to decrease the value of the asset on the balance sheet as it helps produce revenue for the company.
- Salvage Value: The salvage value is defined as the value of the asset at the end of its useful life. Practically, salvage value can be thought of as the amount at which a company can sell the old asset at the end of its useful life.
- Useful Life Assumption: Once purchased, PP&E is a non-current (i.e. long-term) asset that continues to provide benefits to the company for the duration of its useful life, which is an estimate of how long the asset will continue to be used and be of service to the company.
Quick Depreciation Calculation Example
If a manufacturing company were to purchase $100k of PP&E with a useful life estimation of 5 years, then the depreciation expense would be $20k each year under straight-line depreciation.
Therefore, $100k in PP&E was purchased at the end of the initial period (Year 0) and the value of the purchased PP&E on the balance sheet decreases by $20k each year until it reaches zero by the end of its useful life (Year 5).
- PP&E Purchase (Capex) = $100k
- Useful Life Assumption = 5 Years
- Salvage Value (Residual) = $0
- Annual Depreciation = $100k / 5 Years = $20k
Assuming the company pays for the PP&E in all cash, that $100k in cash is now out the door, no matter what, but the income statement will state otherwise to abide by accrual accounting standards. This “smooths out” the company’s income statement so that rather than showing the $100k expense entirely this year, that outflow is effectively being spread out over 5 years as depreciation.
Depreciation Method: Straight-Line vs. Accelerated Rate
There are various depreciation methodologies, but the most common type is called “straight-line” depreciation.
- Straight Line Method: Under the straight line method of depreciation, the carrying value of PP&E on the balance sheet is decreased evenly per year until the residual value has diminished to zero. The majority of companies use a salvage value assumption in which the remaining value of the asset becomes zero by the end of the useful life. In doing so, the depreciation expense each year will be higher, and the depreciation tax benefits are fully realized if the salvage value is assumed to be zero (and this is the common assumption used in straight-line depreciation).
- Accelerated Methods: There are other approaches to calculating depreciation, most notably accelerated accounting, which depreciates the asset faster in earlier years. In turn, this methodology lowers net income more in early years as compared to later years. However, considering how much publicly traded companies care about their net income and earnings per share (EPS) figures – most opt for straight-line depreciation.
At the end of the day, the cumulative depreciation amount is exactly the same, as is the timing of the actual cash outflow, but the difference lies in the net income and EPS impact for reporting purposes.
But in practice, most companies prefer straight-line depreciation for GAAP reporting purposes because lower depreciation will be recorded in the earlier years of the asset’s useful life than under accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income and EPS in the initial years.
Under the accelerated depreciation method, net income and EPS would be lower in the earlier periods and then be higher relative to straight-line depreciation in later years – however, companies tend to prioritize near-term earnings performance.
The assumption behind accelerated depreciation is that the asset drops more of its value in the earlier stages of its lifecycle, allowing for more deductions earlier on.
The accelerated approach eventually begins to show less depreciation on the income statement further into the asset’s useful life, but to reiterate, companies still prefer straight-line depreciation because of the timing (i.e., avoid missing EPS figures on earnings releases).