Depreciation - Important Points
- Choosing a Useful Life – In isolation, the shorter the useful life, the higher the depreciation expense. A company’s management may attempt to show higher earnings in the near-term by increasing the useful life estimates for its long lived assets.
- Estimating Salvage Value – A high salvage value lowers depreciation expense, raising income and equity value. A company’s management may decide to assign a $0 salvage value to its long-lived assets in order to show higher profitability.
- A company’s management may decide to change its depreciation method. The reason could be legitimate or it may signal an attempt to “window dress” (present an artificially optimistic financial report).
An analyst is expected to be able to read the financial statement footnotes to understand the company’s choice of depreciation method.
The disclosure by management of a change in depreciation method should serve as a red flag to a skilled financial analyst and he or she must calculate the impacts of the depreciation method change on key financial ratios.
Depreciation Accounting and Inflation – when a company depreciates PPE at historical cost during a period of rising prices, the true depreciation expense is likely understated. If the historical cost basis for a firm’s depreciation expense is lower than its replacement cost, then an analyst may believe that the company is over reporting net income.
- CFA Level 2: Financial Reporting Part 1 - Introduction
- Financial Reporting: Important Definitions
- FIFO and LIFO Methods for Inventory Expensing
- Inventory Accounting and Financial Statements
- Inflation/Deflation and Inventory Accounting Analysis
- LIFO – Tax and Cash Flow Note
- LIFO Reserve and Converting LIFO Net Income to FIFO Net Income
- LIFO Liquidation
- Inventory at Net Realizable Value
- Impacts of LIFO and FIFO Inventory Methods on Selected Financial Ratios
- Accounting of Long-lived Assets - Expensing vs. Capitalizing
- Depreciation Methods for Property, Plant, and Equipment (PPE)
- Impact of Depreciation Method
- Depreciation - Important Points
- Impairment of Long-lived Assets
- Impact of Asset Impairment
- Revaluation of Property, Plant, & Equipment (PPE)
- Leasing versus Purchasing Assets
- Traditional Lessee Accounting in US GAAP
- Effects of Leases on Selected Financial Reporting Items for Lessees
- Lessor Accounting for Leases
- Lessors and Sales-Type Capital Leases
- Lessors and Direct Financing Capital Leases
- Effect of Leases on Financial Statements for Lessors
- Future of Lease Accounting
- CFA Level 2: Financial Reporting 1 - Recommendations
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