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115 CFA
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115.040.08.03 - Financial Analysis - Reading 26 - 3. Depreciation Methods

# 3. Depreciation Methods

## e. describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios;

Is depreciation an allocation process or a valuation process?
For accountants, depreciation is an allocation process, not a valuation process.

What are the two factors that affect the computation of depreciation?
1. Depreciable cost (acquisition cost - salvage or residual value) and
2. Estimated useful life (depreciable life).
- Note that it is depreciable cost, not acquisition cost, that is allocated over the useful life of an asset.

What are the four different depreciation methods?
1. Straight Line Depreciation (SLD)
2. Accelerated Depreciation Methods
3. Double Decline Balance (DDB)
4. Units of Production (UOP) and Service Hours Method

What is Straight Line Depreciation (SLD)?
- It is based on the assumption that depreciation depends solely on the passage of time.
- $$depreciation\ expense = \frac{cost - salvage\ value}{estimated\ useful\ life}$$

What is Accelerated Depreciation?
More depreciation is allocated to earlier years than to later years. This is consistent with the matching principle because many assets are more useful earlier in their life.

What is the accelerated depreciation method called Sum of Years Digits (SYD)?
- Depreciation expense is based on a decreasing fraction of depreciable cost. The numerator decreases year by year but the denominator remains constant. As a result, this method applies higher depreciation expense in the early years and lower depreciation expense in later years.
- $$sum\ of\ the\ years\ digits = \frac{(cost - salvage\ value)(years\ remaining)}{sum\ of\ years}$$

What does accelerated depreciation methods do to most companies earnings and tax expenses?
An accelerated depreciation method will continuously result in lower reported earnings and tax expenses.

What is Units of Production (UOP) and Service Hours Method of depreciation?
This method assumes that depreciation depends solely on the use of the asset and bases depreciation on actual service usage. More depreciation expense is charged in years of higher production.

What is one advantage and one drawback of Units of Production (UOP) and Service Hours Method of depreciation?
- The advantage is that they make depreciation expense a variable rather than a fixed cost, decreasing the volatility of reported earnings as compared to straight-line or accelerated methods.
- A drawback occurs when the firm's productive capacity becomes obsolete as it loses business to more efficient competitors.

How is the depreciable life of an asset determined?
Depreciable life, also called useful life, is the total number of service units expected from a depreciable asset. It can be measured in terms of units expected to be produced, hours of service to be provided by the asset, or years the asset is expected to be used.

How is salvage value (residual value) determined?
Salvage value, also called residual value, is the estimated amount that will be received when an asset is sold or removed from service.

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