Choice of Depreciation Method and Assumptions

Financial statements and the ratios derived from them may be significantly impacted by a company’s selected depreciation method and accompanying assumptions and estimates.

Companies should review the estimates used periodically to ensure that they remain reasonable.

The Effect of the Choice of Depreciation Method and Assumptions on Depreciation Expense, Financial Statements, and Financial Ratios

The choice of depreciation method will affect the amounts that are reported on the financial statements, including the amounts for reported assets and operating and net income. Several financial ratios will be affected because of this. Among others, the fixed asset turnover, total asset turnover, operating profit margin, operating return on assets, and return on assets will be affected.

In some countries, the same depreciation method is not used for financial reporting and tax purposes. As a result, pre-tax income on the income statement and taxable income on the tax return are likely to differ. The amount of tax expense computed based on pre-tax income and the amount of taxes actually owed based on taxable income may be different.

For example, a company may use the straight-line method of depreciation for financial reporting and an accelerated depreciation method for tax purposes.  In such an instance, the company’s financial statements will report lower depreciation expense and higher pre-tax income in the first year, compared with the amount of depreciation expense and taxable income in its tax reporting. The tax expense that is calculated based on the financial statements’ pre-tax income will be higher than taxes payable based on taxable income. The difference between the two amounts is a deferred tax liability. This deferred tax liability will be reduced as the difference reverses, i.e., when the depreciation for financial reporting becomes higher than the depreciation for tax purposes and the income tax is paid.

Significant estimates are required for calculating depreciation expenses. These include the useful life of an asset and the expected residual value at the end of that useful life. Longer useful life and a higher expected residual value will decrease the amount of annual depreciation expense relative to a shorter useful life and lower expected residual value.

Question 1

Companies A and B purchase a similar machine at the same time and at the same cost. In reporting this acquisition, company A uses the straight-line method of depreciation, while company B uses the double declining balance method. Other than the choice of depreciation method, both companies use similar estimates and assumptions.

Assuming that the machine is the only long-lived asset that both companies report on their financial statements, which of the following statements is the most accurate?

1. Company A and B will have the same tax expense.
2. Company A will have a higher pre-tax income in the first year, than company B.
3. Company A will have a higher depreciation expense in the first year than company B.

Solution

The correct answer is B.

Company A will have a higher pre-tax income in the first year than company B because of its lower depreciation expense under the straight-line method of depreciation.

A is incorrect because company A will have a lower depreciation expense.

C is incorrect because company A will have a higher tax expense in the first year due to its higher pre-tax income.

Question 2

How would an increase in the estimated residual value of an asset affect a company’s net income?

1. It has no effect.
2. It would increase net income.
3. It would decrease net income.

Solution

The correct answer is B.

Increasing the residual value would decrease the annual depreciation expense of the asset. Decreasing the depreciation expense of the asset would therefore increase net income.