Depreciation

The starting point is the depreciable base: capitalised cost, which includes purchase price plus any expenditure required to bring the asset into working condition, minus estimated residual value. That base is then spread over useful life using one of three families of methods.

Straight-line divides the depreciable base by useful life in years, producing an identical charge each period. Declining balance is accelerated: a multiple of the straight-line rate is applied to the opening carrying amount, not to the depreciable base, so the charge falls each year and depreciation stops once carrying amount reaches residual value. Units-of-production ties the charge to output or usage, dividing the depreciable base by total expected units and multiplying by units produced in the period. IFRS additionally requires component depreciation, where parts of an asset with different useful lives, such as an aircraft airframe and its engines, are depreciated separately.

On the income statement, depreciation may sit inside cost of sales, in selling and administrative expense, or on a separate line, depending on how the asset is used. Manufacturers capitalise depreciation of factory equipment into inventory first, so it reaches the income statement only as goods are sold.

On the balance sheet, property, plant and equipment is typically disclosed at gross cost, less accumulated depreciation, giving the net carrying amount. Accumulated depreciation is a contra-asset that grows until the asset is sold, written off or fully depreciated. On the cash flow statement under the indirect method it is a reconciling add-back. Because tax authorities prescribe their own capital allowance schedules, depreciation for tax purposes usually differs from book depreciation, and the timing difference generates deferred tax liabilities that unwind over the asset's life.

Useful life and residual value are management estimates, which makes depreciation one of the most judgement-laden lines in the accounts. Two firms with identical assets can report materially different operating margins simply because one assumes a longer life. Analysts therefore standardise before comparing: recalculating implied average useful life as gross PP&E divided by annual depreciation expense, average age as accumulated depreciation divided by annual depreciation expense, and remaining life as net PP&E divided by annual depreciation expense.

These ratios also flag reinvestment needs. An asset base that is heavily depreciated relative to gross cost signals approaching capital expenditure, while capital spending persistently below depreciation suggests a shrinking productive base. Revisions to useful life or residual value are changes in accounting estimate, applied prospectively to the remaining carrying amount rather than by restating prior periods.

You should be able to compute annual depreciation and closing carrying amount under straight-line, double-declining balance and units-of-production, and to recompute depreciation after a mid-life change in estimate by spreading the remaining carrying amount less revised residual value over the revised remaining life.

Equally important is the directional analysis. Relative to straight-line, an accelerated method raises depreciation and lowers net income, ROA, ROE and net profit margin in early years, then reverses in later years as the charge declines and the asset base shrinks. Total depreciation over the asset's life is identical under every method; only timing differs. Cash flow from operations is unaffected by method choice on a pre-tax basis, though tax depreciation choices do change cash taxes paid. Under IFRS a firm may also elect the revaluation model, after which depreciation is based on the revalued amount.