| -- | End of Year | Beginning of Year | Year-End Difference |
| Plant, Property, and Equipment (PP&E) | $3,600,000 | $3,230,000 | $360,000 |
| Accumulated Depreciation | ($1,200,000) | ($1,050,000) | ($150,000) |
Figure 1
In the above example, $360,000 worth of PP&E was purchased during the year (which would show up under capital expenditures on the cash flow statement) and $150,000 of depreciation was charged (which would show up on the income statement). The difference between the end-of-year PP&E and the end-of-year accumulated depreciation is $2.4 million, which is the total book value of those assets.
If the semi-trailer mentioned above had been on the books for three years by this point, then $9,000 of that $150,000 depreciation would have been due to the trailer, and the book value of the trailer at the end of the year would be $73,000. It does not matter if the trailer could be sold for $80,000 or $65,000 at this point; on the balance sheet, it is worth $73,000.
Impact of a Sale
Suppose that trailer technology has changed significantly over the past three years and the company wants to upgrade its trailer to the improved version while selling its old one. Three scenarios can occur for that sale.
First, the trailer can be sold for its book value of $73,000. In this case, the PP&E asset is reduced by $100,000, and the accumulated depreciation is increased by $27,000 to remove the trailer from the books. (The cash account balance will increase by the sale amount for all cases.)
The second scenario that could occur is that the company really wants the new trailer, and is willing to sell the old one for only $65,000. In this case, three things happen to the financial statements. The first two are the same as above to remove the trailer from the books. In addition, there is a loss of $8,000 recorded on the income statement because only $65,000 was received for the old trailer when its book value was $73,000.
The third scenario arises if the company finds an eager buyer willing to pay $80,000 for the old trailer. As you might expect, the same two balance sheet changes occur, but this time, a gain of $7,000 is recorded on the income statement to represent the difference between the book and market values.
Suppose, however, that the company had been using an accelerated depreciation method, such as double-declining balance depreciation.
Under the double-declining balance method, the book value of the trailer after three years would be $51,200 and the gain on a sale at $80,000 would be $28,800, recorded on the income statement—a large one-time boost. Under this accelerated method, there would have been higher expenses for those three years and, as a result, less net income. There would also be a lower net PP&E asset balance. This is just one example of how a change in depreciation can affect both the bottom line and the balance sheet.
Expected Useful Life and Salvage Value
The expected useful life is another area where a change would impact depreciation, the bottom line, and the balance sheet. Suppose that the company is using the straight-line schedule originally described. After three years, the company changes the expected useful life to a total of 15 years but keeps the salvage value the same. With a book value of $73,000 at this point (one does not go back and "correct" the depreciation applied so far when changing assumptions), there is $63,000 left to depreciate. This will be done over the next 12 years (15-year lifetime minus three years already).
Using this new, longer time frame, depreciation will now be $5,250 per year, instead of the original $9,000. That boosts the income statement by $3,750 per year, all else being the same. It also keeps the asset portion of the balance sheet from declining as rapidly, because the book value remains higher. Both of these can make the company appear "better" with larger earnings and a stronger balance sheet.
Fraud
Investors and analysts should thoroughly understand how a company approaches depreciation because the assumptions made on expected useful life and salvage value can be a road to the manipulation of financial statements.
Similar things occur if the salvage value assumption is changed, instead. Suppose that the company changes salvage value from $10,000 to $17,000 after three years, but keeps the original 10-year lifetime. With a book value of $73,000, there is now only $56,000 left to depreciate over seven years, or $8,000 per year. That boosts income by $1,000 while making the balance sheet stronger by the same amount each year.
The Bottom Line
Depreciation is how an asset's book value is "used up" as it helps to generate revenue. In the case of the semi-trailer, such uses could be delivering goods to customers or transporting goods between warehouses and the manufacturing facility or retail outlets. All of these uses contribute to the revenue those goods generate when they are sold, so it makes sense that the trailer's value is charged a bit at a time against that revenue.
However, one can see that the amount of expense to charge is a function of the assumptions made about both the asset's lifetime and what it might be worth at the end of that lifetime. Those assumptions affect both the net income and the book value of the asset. Further, they have an impact on earnings if the asset is ever sold, either for a gain or a loss when compared to its book value.
If a company routinely recognizes gains on sales of assets, especially if those have a material impact on total net income, the financial reports should be investigated more thoroughly. Management that routinely keeps book value consistently lower than market value might also be doing other types of manipulation over time to massage the company's results.
As a seasoned financial analyst with years of experience in accounting and financial statement analysis, I'll delve into the intricacies of the concepts presented in the provided article. My expertise extends to areas such as depreciation, asset valuation, and their profound impact on financial statements.
In the financial world, Plant, Property, and Equipment (PP&E) play a crucial role in a company's balance sheet. The provided figures illustrate the dynamics of PP&E and Accumulated Depreciation over the course of a year, highlighting a $360,000 increase in PP&E due to purchases and a $150,000 rise in Accumulated Depreciation. The resulting $2.4 million represents the total book value of these assets.
The article then moves to a scenario involving the sale of an asset, a semi-trailer, emphasizing the influence of depreciation methods on financial statements. Whether using straight-line or double-declining balance depreciation, the book value and potential gains or losses on sale differ significantly. This underscores the importance of selecting an appropriate depreciation method and understanding its implications for both net income and the balance sheet.
Expected useful life and salvage value, two critical assumptions in depreciation calculations, are explored next. The article demonstrates how changes in these assumptions can impact depreciation expenses, net income, and the balance sheet. A shift in the expected useful life from 10 to 15 years results in a lower annual depreciation expense, positively affecting the income statement and the asset's book value. Similarly, adjusting the salvage value affects depreciation and, consequently, the financial statements.
The narrative also touches on the potential for manipulation and fraud related to depreciation. Investors and analysts are cautioned to scrutinize a company's approach to depreciation, as changes in assumptions may be used to manipulate financial statements. Such manipulations, especially when recognizing gains on asset sales, can have a material impact on total net income, warranting a closer investigation into the company's financial reporting practices.
In essence, the article underscores the critical role of depreciation in financial reporting and the need for a thorough understanding of the assumptions underlying depreciation calculations. It emphasizes how these assumptions can impact a company's bottom line, balance sheet, and even the perception of its financial health.
