There are always assumptions built into many of the items on
these statements that, if changed, can have greater or lesser effects on the
company's bottom line and/or apparent health. This article looks at how
assumptions in depreciation impact the value of long-term assets and how this
can affect short-term earnings results.
Salvage Values and Depreciation
One of the
consequences of generally accepted accounting principles (GAAP) is that while
cash is used to pay for a long-lived asset, such as a semi-trailer to deliver
goods, the expenditure is not listed as an expense against revenue at the time.
Instead, the cost is placed as an asset onto the balance sheet and that value
is steadily reduced over the useful lifetime of the asset. This reduction is an
expense called depreciation. This happens because of the matching principle
from GAAP, which says expenses are recorded in the same accounting period as
the revenue that is earned as a result of those expenses.
For example, suppose
the cost of a semi-trailer is $100,000 and the trailer is expected to last for
10 years. If the trailer is expected to be worth $10,000 at the end of that
period (salvage value), $9,000 would be recorded as a depreciation expense for
each of those 10 years (cost - salvage value/number of years).
Note: This example uses the straight-line method of
depreciation and not an accelerated depreciation method that records a larger
depreciation expense during the earlier years and a smaller expense in later
years. There are also two assumptions built into the depreciation amount: the
expected lifetime and the salvage value.
Long-Term Assets
If you look at the
long-term assets, such as property, plant and equipment (PP&E), on a
balance sheet, there are often two lines showing the cost value of those assets
and how much depreciation has been charged against that value. (Sometimes,
these are combined into a single line such as "PP&E net of
depreciation".)
-- End Of Year Beginning Of Year Year-End
Difference
Plant, Property & Equipment (PP&E)
$3,600,000
$3,230,000
$360,000
Accumulated Depreciation
(1,200,000)
(1,050,000)
($150,000)
Figure 1
In the above example,
$360,000 worth of PP&E was purchased during the year (which would show up
under capital expenditures on the cash flow statement) and $150,000 of
depreciation was charged (which would show up on the income statement). The
difference between the end-of-year PP&E and the end-of-year accumulated
depreciation is $2.4 million, which is the total book value of those assets. If
the semi-trailer mentioned above had been on the books for three years by this
point, then $9,000 of that $150,000 depreciation would have been due to the
trailer and the book value of the trailer at the end of the year would be
$73,000. It does not matter if the trailer could be sold for $80,000 or $65,000
at this point (market value) - on the balance sheet it is worth $73,000.
Suppose that trailer
technology has changed significantly over the past three years and the company
wants to upgrade its trailer to the improved version, while selling its old
one. There are three scenarios that can occur for that sale. First, the trailer
can be sold for its book value of $73,000. In this case, the PP&E asset is reduced
by $100,000 and the accumulated depreciation is increased by $27,000 to remove
the trailer from the books. (The cash account balance will increase by the sale
amount for all cases.)
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The second scenario
that could occur is that the company really wants the new trailer, and is
willing to sell the old one for only $65,000. In this case, three things happen
to the financial statements. The first two are the same as above to remove the
trailer from the books. In addition, there is a loss of $8,000 recorded on the
income statement because only $65,000 was received for the old trailer when its
book value was $73,000.
The third scenario
arises if the company finds an eager buyer willing to pay $80,000 for the old
trailer. As you might expect, the same two balance sheet changes occur, but
this time a gain of $7,000 is recorded on the income statement to represent the
difference between book and market values.
Suppose, however,
that the company had been using an accelerated depreciation method, such as
double-declining balance depreciation. (See Figure 2 below for the difference
in depreciation between straight-line and double-declining depreciations on
$100,000.) Under the double-declining balance method, the book value of the
trailer after three years would be $51,200 and the gain on a sale at $80,000
would be $28,800, recorded on the income statement - quite a one-time boost!
Under this accelerated method, there would have been higher expenses for those
three years and, as a result, less net income. There would also be a lower net
PP&E asset balance. This is just one example of how a change in
depreciation can affect both the bottom line and the balance sheet.
Straight-Line
(10% of begin-salvage
every year) Double-Declining
(20% of year\'s
beginning book
value every year)
-- Depr Book Accum Depr Book Accum
1
9,000
91,000
9,000
20,000
80,000
20,000
2
9,000
82,000
18,000
16,000
64,000
36,000
3
9,000
73,000
27,000
12,800
51,200
48,800
4
9,000
64,000
36,000
10,240
40,960
59,040
5
9,000
55,000
45,000
8,192
32,768
67,232
6
9,000
46,000
54,000
6,554
26,214
73,786
7
9,000
37,000
63,000
5,243
20,972
79,028
8
9,000
28,000
72,000
4,194
16,777
83,223
9
9,000
19,000
81,000
3,355
13,422
86,578
10
9,000
10,000
90,000
3,422
10,000
90,000
Source:
"Financial Accounting", John. J. Wild
Figure 2: Begin
100,000, Salvage 10,000
Expected lifetime is
another area where a change in depreciation will impact both the bottom line
and the balance sheet. Suppose that the company is using the straight-line
schedule originally described. After three years, the company changes the
expected lifetime to a total of 15 years but keeps the salvage value the same.
With a book value of $73,000 at this point (one does not go back and
"correct" the depreciation applied so far when changing assumptions),
there is $63,000 left to depreciate. This will be done over the next 12 years
(15-year lifetime minus three years already). Using this new, longer time
frame, depreciation will now be $5,250 per year, instead of the original
$9,000. That boosts the income statement by $3,750 per year, all else being the
same. It also keeps the asset portion of the balance sheet from declining as
rapidly, because the book value remains higher. Both of these can make the
company appear "better" with larger earnings and a stronger balance
sheet.
Similar things occur
if the salvage value assumption is changed, instead. Suppose that the company
changes salvage value from $10,000 to $17,000 after three years, but keeps the
original 10-year lifetime. With a book value of $73,000, there is now only
$56,000 left to depreciate over seven years, or $8,000 per year. That boosts
income by $1,000 while making the balance sheet stronger by the same amount
each year.
Watch For Assumptions
Depreciation is the
means by which an asset's book value is "used up" as it helps to
generate revenue. In the case of our semi-trailer, such uses could be
delivering goods to customers or transporting goods between warehouses and the
manufacturing facility or retail outlets. All of these uses contribute to the
revenue those goods generate when they are sold, so it makes sense that the
trailer's value be charged a bit at a time against that revenue.
However, one can see
that how much expense to charge is a function of the assumptions made about
both its lifetime and what it might be worth at the end of that lifetime. Those
assumptions affect both the net income and book value of the asset. Further,
they have an impact on earnings if the asset is ever sold, either for a gain or
a loss when compared to its book value.
While companies do
not break down the book values or depreciation for investors to the level
discussed here, the assumptions they use are often discussed in the footnotes
to the financial statements. This is something investors might wish to be aware
of. Furthermore, if a company routinely recognizes gains on sales of assets,
especially if those have a material impact on total net income, the financial
reports should be investigated more thoroughly.
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