Do Depreciation Methods Affect Net Profit?

Written by marquis codjia
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Companies generally implement adequate asset management procedures to ensure that accounting statements are accurate and complete. An asset is an economic resource that an organisation owns or on which it can claim ownership at a future date. Depreciation ensures that a company allocates costs associated with corporate assets in financial reports, particularly in the statement of profit and loss.

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Identification

Depreciation is an accounting practice that enables organisations to spread the costs of long-term assets over several years. Long-term assets are also referred to as fixed or capital resources, and include real estate, plants and equipment. Straight-line and accelerated methods are the most common depreciation techniques. Both methods affect a company's net profit because depreciation is an operating expense. Net profit, or net income, equals corporate revenues minus expenses.

Types

Straight-line and accelerated depreciation methods affect net profit in different ways. In a straight-line process, a corporate book-keeper records the same depreciation amount evenly over the asset's useful life---that is, the period over which management believes the asset will serve in operating activities. If a company opts for an accelerated method, the book-keeper records higher depreciation amounts in earlier years.

Significance

As a business practice, depreciation plays an important role in long-term decision-making processes, according to accounting instructor and certified public accountant Harold Averkamp. Corporate leadership pays attention to depreciation methods because they affect not only net profit but other key financial indicators such as operating income and working capital. Operating income equals gross revenues minus materials costs. Working capital gauges short-term cash availability and equals current assets minus current liabilities. A company's depreciation policies also affect its fiscal liability, as Internal Revenue Service depreciation guidelines generally differ from financial accounting rules.

Impact on Net Profit

As an operating expense, depreciation affects net income. For example, a large car-seat manufacturer depreciates its fixed assets using a straight-line method. In total, the company's assets are worth £65 million, and their average useful life is 10 years. Accordingly, total annual depreciation equals £6 million ($100 million divided by 10), and the firm's annual net profit will decrease by the same amount. Assuming the controller selected a "50-30-20 accelerated method," total depreciation for the first year would be £32 million ($100 million times 50 per cent). As a result, the company's net profit would decrease by £32 million.

Considerations

In addition to net profit, depreciation methods also affect other financial indicators and accounting reports. These financial statements include balance sheets or statements of financial position, statements of cash flows and statements of retained earnings. Although it impacts net income, depreciation is a noncash item, meaning a company does not pay for it.

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