How to Compare Depreciation Methods

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Once you understand the basic depreciation methods for calculating depreciation expense on an income statement and accumulated depreciation on a balance sheet, you should then compare depreciation methods—the things that matter, the things that don't matter, and general observations about their various influences on reported profitability and shareholders' equity.

Depreciation Methods' Influence on Intrinsic Value

Successful businesses tend to be light on assets because their returns on capital are so high.

 There are still many good and great businesses that don't fall into this category but, all else equal, it's true. Depreciation policies aren't going to have much of an influence on the calculation of intrinsic value for a firm such as Microsoft or Visa, but they are going to be of the utmost importance when analyzing Union Pacific or Alcoa. 

Owner's Earning Calculation vs. Earnings Per Share in Isolation

This is the reason that you may prefer using an owner's earning calculation rather than looking at earnings per share in isolation. For example, with Union Pacific, real economic profits are lower than the reported profits found at the bottom of the income statement.

Aside from that, there can be a lot of variation in the reported financial figures from year-to-year even when the underlying situation is identical. To make this point review one of the depreciation examples you've been calculating thus far.

Imagine you were examining a business that acquired an asset for $100,000. 

This asset had a $10,000 estimated salvage value and you expected it to have a useful life of ten years. Despite economic reality being exactly the same in each case, here is the difference in the depreciation expense that would be charged to the income statement in each year depending on the depreciation methodology used in the preparation of its balance sheet and income statement.

Straight-Line Depreciation Methods and Profitability

 

Despite no difference other than the accounting methodology, in, say, year nine, a company using the straight-line depreciation method is going to appear to be far less profitable than one using the sum of the years' digit or double declining balance depreciation method while, at the same time, having a much higher net worth resulting in a seemingly lower return on capital.  

Also note that some management will report depreciation expense broken out as a separate line on the income statement, while others will be more clandestine about it, including it indirectly through selling, general, and administrative (SG&A) expenses, for example, for the depreciation costs of desks.

Either way, you should be able to garner the information either through the income statement or through the annual report or Form 10-K filing.  You'll also want to compare a company's depreciation practices to other firms in its sector or industry because some management may be tempted to set unreasonably high estimated salvage values on assets, resulting in lower depreciation expense than peers.

Comparing Depreciation Methods

MethodYear 1Year 2Year 3
Straight Line$1,600.00$1,600.00$1,600.00
Sum of the Years$2,400.00$1,599.84$800.16
Double Declining Balance$3,200.00$1,600.00$0.00