Problems With Depreciation

There are three different depreciation methods available to companies when writing off assets. Thus, one of the problems with depreciation is that it based on management's discretion. When a company depreciates an asset, it is making an estimation on the useful life of that asset. Depending on which depreciation method is used, a company can be too aggressive in writing off assets or its estimate of an asset's useful life may be over-exaggerated.

The three types of depreciation methods are straight-line, double declining balance (DDB), and sum-of-the-years digits (SOYD). Straight-line depreciation evenly spreads the cost of depreciation over the life of the asset, whereas DDB and SOYD are considered aggressive forms of depreciation. For example, a company using DDB will report higher depreciation expense than one using straight-line. For analytical purposes, since depreciation is a non-cash expense, it is subtracted from operating expenses but added back to cash flows from operations. A company using DDB will show lower operating expenses and better cash flow, which may not be truly representative.

Companies can use depreciation to manipulate earnings. A company can extend the use of its assets by claiming a longer useful life. When looking at depreciation, it is useful to compare depreciation practices of a company along with its peers. A company's assets may be outdated or in need of repair if it is depreciating assets too slowly. All else being equal, lower depreciation expense means higher net income.

Mark-to-market in accounting refers to the valuation of assets based on current market prices rather than book value. A major distortion occurs in depreciation based on an assets book value versus the actual market value of an asset. For example, a company may have fully depreciated its land and buildings even though these assets have significant market values. This is a common occurrence with intangible assets such as logos and trademarks. For accounting purposes, these intangible assets have a finite life; however, in reality these assets can be extremely valuable.

It is useful to compare a company's depreciation methods with that of its peers. Usually, companies within the same industry use similar depreciation methods. If a company is using DDB, convert this to the more conservative straight-line depreciation method. After doing this, you may want to subtract the more conservative depreciation method from operating expenses to get a better picture of the company's financial health and for better peer comparisons. Similarly, you may want to value a company's assets based on current market prices rather than book value.