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Comparing Depreciation Methods

Investing Lesson 4 - Analyzing an Income Statement


Comparing Depreciation Methods
To reinforce what we've learned thus far, here's a look at what the depreciation charges for the same $5,000 computer would look like depending upon the method used (the chart is at the bottom of this page).

Obviously, depending upon which method is used by management, the bottom-line reported profits of a company can vary greatly from year to year. The level of attention an investor must give depreciation depends upon the asset intensity of the business he or she is studying. The more asset-intensive an enterprise, the more attention depreciation should be given. In other words, you should understand the depreciation philosophy behind every management team when you are examining businesses that require huge plants, factories, equipment, and capital expenditure investment. This is much less important when analyzing businesses that are not asset intensive, such as software companies, advertising agencies, or insurance brokers.

If you have two asset intensive businesses, and they are using different depreciation methods, and / or useful lives, you must adjust them so they are on a comparable basis in order to get an accurate picture of how they stack up against each other in terms of profit.

Some managements 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 SG&A expenses (for the deprecation costs of desks, for instance). Either way, you should be able to garner the information either through the income statement itself or going through the annual report or 10K.

Benjamin Graham's 3 Recommended Depreciation Questions
In the classic 1934 edition of Security Analysis, Benjamin Graham recommended the investor answer three questions when dealing with the effects of deprecation on a business (paraphrased):

1. Is depreciation reflected in the earnings statement? Today this, is a moot point because GAAP accounting rules require that all companies report depreciation. This was not the case in the past.

2. Is management using conservative and (as much as possible) accurate depreciation rates? Accounting rules allow assets to be written off over a considerable time period. Buildings, for example, can be depreciated anywhere from ten to thirty years, resulting in large differences in charges depending upon the time frame a particular business uses. A company's 10K filing should contain information on the depreciation rates employed by the company.

3. Are the cost or base to which the depreciation rates applied reasonably accurate? A company may set unrealistically high salvage values on its assets, thus reducing the amount of depreciation charges it must take every year.

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This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.

Comparing Depreciation Methods

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

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