Level 1 CFA® Exam:
Depreciation & Amortization Methods

Thus, the following part of this lesson will be devoted to depreciation. Note, however, that everything we will say also relates to amortization.

Depreciation in accounting is the allocation of the purchase price or production cost throughout the useful life of a long-lived asset. Depreciation can be reported in financial statements using 3 different methods:

• the straight-line method,
• accelerated methods, and
• the units-of-production method.

Before discussing them in detail, we need to explain 2 terms, namely:

• expected useful life and
• expected residual value of an asset.

Expected useful life of a long-lived asset is an estimated period of time in which the asset is going to bring an economic benefit to the company.

Expected residual value is the value of a long-lived asset when its useful life is over.

Both the expected useful life and expected residual value are a result of estimations made by the company, and their values have a direct impact on amortization or depreciation expenses which, in turn, affect the values of the net profit and financial ratios of the company.

Straight-Line Method

We start with the straight-line method. According to this method, the value of a depreciation expense is the same in each period. Therefore, we will calculate an amortization or a depreciation expense in a given year following this formula:

Depreciation expense is the same for each year and it is equal to the historical cost minus the expected residual value of the asset divided by the expected useful life of the asset.

Accelerated Methods

Accelerated methods assume higher levels of depreciation for the earlier periods, and lower – for the subsequent ones. A typical example of this approach is the method called double-declining balance method.

Depreciation rate of the double-declining balance method is 2 times higher than the depreciation rate of the straight-line method. So, if we use the straight-line method for a particular asset and the depreciation rate is 10%, then if we used the double-declining balance method instead, the depreciation expense would be 20%.

Note, however, that according to the double-declining balance method the depreciation expense occurring in the first year won’t be exactly two times higher than the depreciation expense obtained with the aid of the straight-line method. This is because when we calculate the depreciation expense using the accelerated method, we don’t subtract the expected residual value from the net book value of the asset.

Also, remember that the carrying value should not fall below the expected residual value. This applies to all methods.

Units of Production Method

According to the units-of-production method, depreciation expense in a given period depends on the expected production volume in this period. To compute the depreciation expense in a given year, we first divide the expected production volume in this year by the total production capacity during the life of the long-lived asset. Then, this ratio is multiplied by the difference between the historical cost and the residual value of the assets.

Pretax Income vs Taxable Income

Let’s say a few words about differences that may arise between pretax income and taxable income if we use different methods of amortization and depreciation for accounting and tax purposes.

For financial reporting purposes, companies in the United States mostly use the straight-line method of depreciation and amortization. In turn, for tax purposes often accelerated methods are used. Thanks to it in the earlier periods of the asset’s useful life, taxable income is reduced, which results in lower tax paid and the occurrence of deferred tax liability in the statement of the financial position. In later periods, when depreciation for tax purposes is lower than depreciation in the income statement, the deferred tax liability is reduced.

Expected Useful Life & Residual Value

The longer the expected useful life, the lower the depreciation expense, which means lower costs and a higher level of net profit. And vice versa: the shorter the expected useful life, the higher the depreciation expense, which results in higher costs and a lower level of net profit.

A higher residual value will translate into a lower level of depreciation expense and a higher net profit, while a lower residual value will entail higher depreciation expense and lower net profit.

Accounting standards allow a large degree of flexibility in estimating the useful life and the residual value, as well as in choosing depreciation and amortization methods. Thus, companies gain an important tool for managing the amount of income over time. For example, the higher the first depreciation expense, the lower the first-period net profit. However, in future periods the net profit gets higher due to lower depreciation expenses.

You should know that we can change the depreciation method during the life of the asset. It should be noted, however, that this change has no effect on the preceding periods and affects future periods only.

Changes are permitted also for the expected useful life and the residual value of the asset. To be more precise, a company should periodically check the assumptions and estimations related to its long-lived assets and adjust them if necessary.

Important! All methods and examples that we have discussed in this lesson relate both to tangible assets and depreciation and to intangible assets with finite useful lives and amortization.

1. Two models of determining the value of an asset in subsequent periods are: the cost model and the revaluation model.
2. U.S. GAAP allows the cost model only, while according to IFRS both methods can be used.
3. According to the cost model, a long-lived asset is reported at historical cost and its value is adjusted down by amortization or depreciation expenses.
4. The revaluation model says an asset is reported in a given period at its fair value minus accumulated depreciation or amortization.
5. The net book value of the asset is also called the carrying amount or carrying value of the asset.
6. Expected useful life of a long-lived asset is an estimated period of time in which the asset is going to bring an economic benefit to the company.
7. Expected residual value is the value of a long-lived asset when its useful life is over.
8. There are 3 basic methods of depreciation and amortization: the straight-line method, accelerated methods, and the units of production method.
9. According to the straight-line method, all depreciation expenses have the same value.
10. According to accelerated methods, depreciation expenses are lower from period to period.
11. According to the cost model, a long-lived asset is reported at historical cost and its value is adjusted down by amortization or depreciation expenses.
12. The revaluation model says an asset is reported in a given period at its fair value minus accumulated depreciation or amortization.
13. The net book value of the asset is also called the carrying amount or carrying value of the asset.
14. Expected useful life of a long-lived asset is an estimated period of time in which the asset is going to bring an economic benefit to the company.
15. Expected residual value is the value of a long-lived asset when its useful life is over.
16. According to the units of production method, a depreciation expense in a given period relates to the estimated amount of the productivity of the long-lived asset in this period.
17. When calculating a depreciation expense using accelerated methods, you shouldn’t take the expected residual value into account.
18. The longer the expected useful life, the lower the depreciation expense, which means lower costs and a higher level of net profit.
19. A higher residual value will translate into a lower level of depreciation expense and a higher net profit.