How Depreciation Methods Could Affect Investors' Decisions in Investing

When looking at the different methods of depreciationwith an example firm.  Joe's Hotdogs buys a new
an investor need to take caution when looking at thefryer for his fries for $2,000.  Joe's Hotdogs
numbers on a financial statement.  Just because theestimates that the system has a depreciation expense
companies have good earnings per share or low bookvalue of $500 and it will last about 15 years. 
value there is different accounting methods used toAccording to the straight-line method, Joe's
produce the figures.  We will focus on depreciationdepreciation expense in the first year after buying the
methods and how it can affect the income statementnew fryer would be calculated as follows:
of a company.($2,000 - $500)/30 = $50
                Depreciation is the processUsing the double declining method:
by which a company allocates an asset's cost over2(($2,000 -$500)/30) =
the duration of its useful life. Each time a company Â Â Â Â Â Â Â Â Â Â Â 
prepares its financial statements, it records aSo, the numbers show that if Joe's Hotdogs uses the
depreciation expense to allocate a portion of the coststraight-line method, depreciation costs on the income
of the buildings, machines or equipment it hasstatement will be significantly lower in the first years of
purchased to the current fiscal year. The purpose ofthe asset's life ($50 rather than the $100 rendered by
recording depreciation as an expense is to spread thethe double declining depreciation schedule).
initial price of the asset over its useful life.Looking at the two numbers there is an impact on
                Management of theearnings.  If Joe's Hotdogs was looking to cut costs
company makes decisions on the depreciation, theand boost earnings per share, it will choose the
method and rate of depreciation and the useful life ofstraight-line method, which would boost its bottom line.
the asset.  There are a few different methods for                Most investors look at the
depreciation expense.  Let's go over the two mostnet asset value which some think would offer an
common methods, Straight-line method and Doubleunbiased and precise metric.    Joe's Hotdogs net
declining depreciation.worth means deducting all external liabilities on the
                The Straight-line methodbalance sheet from the total assets, after accounting
takes a depreciation value of the asset at the end offor depreciation. As a result, since the value of net
its life and subtracts it from its original cost. This resultassets doesn't shrink as quickly, straight-line
is then divided by management's estimate of thedepreciation gives Joe's Hotdogs a bigger book value
number of useful years of the asset. The companythan the value a faster rate would give.
expenses the same amount of depreciation each                Things to look at that can
year.  The formula of the straight-line method looksmake Joe's Hotdogs depreciation methods
like this: Straight line depreciation = (original costs ofquestionable.  First off taking a long life of the fryer of
asset – depreciation value)/estimated asset life.30 years, fryers could break down or replace before
                The double decliningthat I would say that a reasonable life of a fryer should
depreciation method write-off depreciation costs morebe about 15 -20 years.  The depreciation expense
quickly than the straight-line method. The purposevalue is a little high.  It would be hard to believe they
behind this method is to minimize the taxable income.could fetch a value of a fryer for $500 after using it
This method basically doubles the rate of depreciationfor 10 years.  Let's look at the reasons why Joe's
of the straight-line method.  The double decliningHotdogs would use these values and method.  The
depreciation formula looks like this: Double Declininglonger the useful life of an asset and the greater the
Depreciation = 2 x (original costs of asset –depreciation expense value, the less its depreciation will
depreciation value / estimated asset life asset life).be over its life. Lower depreciation raises reported
                What does it mean byearnings and net worth. Joe's Hotdogs inputted values
choosing one of the methods? The depreciationfor depreciation will improve the appearance of its
method affects an income statement and balancefundamentals.
sheet in the short term. Let's look at the two methods