Contrast depreciation methods and analyse how estimates change the results

CFA® Level I · Financial Statement Analysis · Analysis of Long-Term Assets · FSA.7.b

The idea

Straight-line depreciation charges an equal amount each year. Accelerated methods such as declining balance charge more early and less later, and units-of-production charges in proportion to use. Whichever method is chosen, two estimates do as much work as the method: the useful life and the residual value, both set by management. A longer assumed life lowers the annual charge and raises reported profit, and comparing a company's average depreciation rate with its peers is the quickest test of whether its estimates are conservative or generous.

Formulas

Straight-line depreciation

depreciation each year = (cost − salvage value) ÷ useful life

cost: what the asset cost to acquire and make ready for use
salvage value: what it is expected to be worth at the end
useful life: the years it is expected to be used for

Two estimates management makes, and both flatter earnings when set generously: a longer life or a higher salvage value lowers this year's expense. That is why a change in either is disclosed.

Double declining balance depreciation

depreciation = (2 ÷ useful life) × beginning book value

useful life: the years the asset is expected to be used for
beginning book value: cost less the depreciation taken so far, at the start of the year

Accelerated, so early years carry more expense and later years less — the total over the asset's life is the same. Salvage value does not enter the calculation but does stop it: depreciation ceases once book value reaches it.

A practice question

From the question bank, with the reason each wrong option is wrong.

How does an accelerated depreciation method affect early-year profit compared with straight line?

It raises itWhy not: Backwards. Accelerated means a larger charge early, which depresses early profit and lifts later profit.
It lowers it — correct
It leaves it unchangedWhy not: Cumulative depreciation over the asset's life is unchanged; the annual charges are not. That redistribution is the whole difference between the methods.

A larger charge in the early years reduces reported profit then and increases it later. Cumulative depreciation over the asset's life is identical.

A harder one

What is the effect of assuming a longer useful life for an asset?

Higher annual depreciation and lower reported profitWhy not: Backwards. The same cost spread over more years is a smaller charge each year.
No effect, since total depreciation is fixedWhy not: The total is indeed fixed, which is exactly why lengthening the life must lower each year's share of it.
Lower annual depreciation and higher reported profit — correct

The same cost spread over more years means a smaller charge each year. The estimate is management's and is disclosed but not verifiable in advance.

The hardest tier

How can an analyst test whether a company's depreciation estimates are aggressive?

By comparing its depreciation expense as a percentage of gross property and equipment with its peers — correct
By recalculating depreciation under an accelerated methodWhy not: That tests the method, not the estimate. A generous useful life stays generous whichever schedule is applied to it.
By comparing its capital expenditure with its revenueWhy not: A useful measure of capital intensity, but it says nothing about the lives assumed for assets already owned.

The implied average rate is a direct comparison of assumed lives across companies with similar assets. A materially lower rate is either a genuinely longer-lived asset base or a generous estimate, and the notes distinguish them.

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