Investments, tenth edition

  Depreciation 

 Another source of problems is the measurement of depreciation, which is a key factor in 

computing true earnings. The accounting and economic measures of depreciation can dif-

fer markedly. According to the  economic  definition, depreciation is the amount of a firm’s 

operating cash flow that must be reinvested in the firm to sustain its real productive  capacity 

at the current level. 

 The   accounting  measurement is quite different. Accounting depreciation is the amount 

of the original acquisition cost of an asset that is allocated to each accounting period over 

an arbitrarily specified life of the asset. This is the figure reported in financial statements. 

 Assume, for example, that a firm buys machines with a useful economic life of 

20 years at $100,000 apiece. In its financial statements, however, the firm can depreci-

ate the machines over 10 years using the straight-line method, for $10,000 per year 

in depreciation. Thus after 10 years a machine will be fully depreciated on the books, 

even though it remains a productive asset that will not need replacement for another 

10 years. 

 In computing accounting earnings, this firm will overestimate depreciation in the first 

10 years of the machine’s economic life and underestimate it in the last 10 years. This will 

cause reported earnings to be understated compared with economic earnings in the first 

10 years and overstated in the last 10 years. 

 Depreciation comparability problems add one more wrinkle. A firm can use different 

depreciation methods for tax purposes than for other reporting purposes. Most firms use 

accelerated depreciation methods for tax purposes and straight-line depreciation in pub-

lished financial statements. There also are differences across firms in their estimates of the 

depreciable life of plant, equipment, and other depreciable assets. 

 Another complication arises from inflation. Because conventional depreciation is based 

on historical costs rather than on the current replacement cost of assets, measured depreci-

ation in periods of inflation is understated relative to replacement cost, and  real   economic 

income (sustainable cash flow) is correspondingly overstated. 

 For example, suppose Generic Products, Inc., has a machine with a 3-year useful 

life that originally cost $3 million. Annual straight-line depreciation is $1 million, 

regardless of what happens to the replacement cost of the machine. Suppose inflation 

in the first year turns out to be 10%. Then the true annual depreciation expense is 

$1.1 million in current terms, whereas conventionally measured depreciation remains 

fixed at $1 million per year. Accounting income overstates  real  economic income by 

$.1 million.