Depreciation 101 for the CFA Level 1
Depreciation and amortization are significant considerations for an analyst. The way we deal with them impacts a firm's balance sheet, income statement, and profitability over time (and can complicate facilitating comparisons).
On the CFA Level 1 exam you are guaranteed to see questions testing this material, including calculations using the straight line and double-declining balance methods and questions around how the residual value and useful life estimates impact depreciation.
Understanding Depreciation for CFA L1
Depreciation is the practice of allocating the cost of long-lived assets over the life of the asset. We use the term depreciation when talking about tangible assets, depletion for natural resources, and amortization when referencing intangible assets.
- Most tangible assets are listed at carrying, or book value (cost + install/transport $)
- PPE is carried on the balance sheet at historical cost – accumulated depreciation (this cost model is required under US GAAP and permitted under IFRS).
Depreciation is measured using either the straight-line or accelerated method. An analyst needs to understand whether the economic depreciation (actual decline in value of the asset) is higher or lower than the reported depreciation expense.
Straight-line and Double-Declining Balance Depreciation Methods
The straight-line method recognizes an equal amount of depreciation each period. It is calculated as:
Where RV is the residual value or salvage value
A company can also use an accelerated depreciation method which front-loads more of the depreciation expense earlier in the life of the asset. This can be more appropriate when the asset generates more benefits in the early years of its economic life.
One version of this is the declining balance method, which applies a constant rate of depreciation to an asset’s (shrinking) book value. The double-declining balance method is the most common example of this type of accelerated method.
This method applies a 2x multiple of the straight-line rate to the declining balance. So if an asset’s life is 20 years, the straight line rate is 1/20 5% and the DDB rate would be 2/20 = 10%.
We calculate this as:
Depreciation ends when the asset hits its residual/salvage value.
Units of Production Depreciation
There is also a units of production depreciation method (which is much less likely to be tested).
The units of production method calculates depreciation based on asset usage instead of time. Depreciation expense is thus higher in periods where the asset is used more. One of the drawbacks of this method is that if demand for the product slows depreciation expense also decreases, which can lead to overstating reported income and asset value. You will most often see this method when calculating the depletion rate of a natural asset.
We calculate unit-of-production depreciation as:
Comparing the Three CFA L1 Methods of Depreciation
Basic takeaways between the three methods:
- Straight-line depreciation- Steady income stream, tax expense and ratios. ROA ↑ over time
- Per unit of production - Produce a variable depreciation expense and more varied net income. May be more reflective of production-to-cost (matching principle).
- Declining balance- Income will be lower in the first years, meaning taxes will be lower and CFO will be higher. ROA will be much higher over time.
And going into a little more depth:
The straight-line method results in lower depreciation expense in the early years and thus higher net income/operating profit while the reverse is true in the later years
- The straight-line method will result in a lower asset turnover ratio during the early years because net assets will be higher
- The straight-line method will result in higher ROA in the early years (due to lower depreciation expense) and lower ROA in the later years
- A company using an accelerated depreciation method will show improving asset turnover ratios, operating profit margin, and ROA over time
Finally recall that intangible assets with finite lives are amortized over their useful lives in an effort to match their benefits to their costs. The process of calculating the amortization expense for these types of assets is the same as depreciation.
Impact of Depreciation Assumptions and Estimates
As we’ve seen, both the residual value and useful life of a long-lived asset forms a key part of calculating its depreciation expense. Manipulating either of them can affect depreciation expense and thus net income.
- A longer useful life decreases annual depreciation & increases net income
- A higher residual (salvage) value decreases depreciation & increases NI
Because they are considered changes in accounting estimates (not principles) there is no need to restate previous financial statements when these values are changed. Because of this degree of latitude analysts should pay careful attention to management’s treatment of these estimates.
For example, management could write-down the value of long-lived assets. This would depress earnings in the current year but allow the company to recognize a much lower annual depreciation expense going forward which could inflate profits and help give the impression of growth in profitability.
Component depreciation refers to the fact that (under IFRS) a firm must list the depreciation of each component of an asset separately. So a building’s plumbing, electrical, and structure all have different depreciation estimates.
On the CFA L1 exam: Watch out for having to separately calculate depreciation for several components (often using different methods) and then add them up to get total depreciation.