Sunday, May 9, 2010

How Companies Calculate Depreciation

Basically, there are two possible ways for companies to calculate depreciation.
1) Straight line depreciation method, or
2) Accelerated depreciation method.

Straight line depreciation is calculated by spreading the asset cost evenly over the assumed lifespan of the fixed asset. Starhub, a telco in Singapore, uses this.

Accelerated depreciation is done by expensing a large part of the cost at the beginning of the life of the fixed asset, and lesser at the end. Cars in general undergo such depreciation; the moment you buy a car and use it for a very short time, the value would have depreciated by more than a proportionate amount.

The required variables for calculating depreciation are the cost and the expected life of the fixed asset. Salvage value may also be considered. Examples of depreciation calculations for both straight line and accelerated methods are provided below.

1) Straight Line Depreciation Method

Straight line depreciation method divides the cost by the lifespan of the asset.

i.e. Straight Line Depreciation = Cost / Lifespan

If a computer is purchased for $2000, and its expected lifespan is 5 years. The annual depreciation is calculated by $2000 / 5 = $400. For each year of the 5 years, $400 would be expensed as depreciation in the balance sheet.

Note..... what if the computer last longer than 5 years? Think about this!

2) Accelerated Depreciation Method

An example of accelerated depreciation method is the Declining Balance Depreciation Method. This method uses the depreciable value of an asset multiplied by a factor which is based on the lifespan of the asset. The depreciable value of this asset is the book value of the asset, or rather, the cost of the asset less the accumulated depreciation.

The factor is calculated taking the percentage of the asset that would be depreciated each year using the straight line depreciation method above, then multiplying by the acceleration factor. For example, the computer above... For a lifespan of 5 years, the yearly depreciation is 20%. If we take a factor of 2 (double declining balance method), then we would take 40%.

Depreciation factor ==> 0.4
120002000 * 0.4800800
212001200 * 0.44801280
3720720 * 0.42881568
4432432 * 0.4172.81740.8
5259.2259.2 * 0.4103.681844.48

There are other methods for accelerated depreciation as well, but I guess I'm too lazy to find out. Basically, the company I'm looking at, Starhub, uses straight line depreciation method. Back to my original question of what if the computer lasts more than 5 years?

After 5 years, the full cost of the computer has been depreciated. However, if the computer is still functioning well, it would still be used of course! But it would not be listed in the balance sheet any more since it has been fully depreciated, unless the company wants it to (somehow); it will not be calculated as part of NAV or Book Value when fully depreciated. Please correct me if I'm wrong in this aspect.

Compare this to Starhub. How often does Starhub need to change it's underground cables for it's pay TV, or wireless repeaters for its mobile customers? Just something to ponder for infrastructure stocks like telcos....

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