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).
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An analyst is expected to be able to read the financial statement footnotes to understand the company’s choice of depreciation method.
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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.
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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.