Depreciation Methods and Their Impact on Ratios

A large body of scholarly literature exists relating to the subject of choices of accounting methods. The choice of depreciation methods is an example of these accounting choices. The choice of depreciation method affects several ratios.

Required:

1. Explain which financial statement ratios are affected by the choice of depreciation methods, with specific attention to the effects of straight-line vs. accelerated depreciation on the ratios.

2. Comment on the effects on financial statement users of the issues discussed in part 1

Sample Paper

Depreciation Methods and Their Impact on Ratios

Methods applied in capturing the long-term cost of assets in companies often have different implication in financial statements and balances sheet. Depending on the method applied, an asset may be valued differently with the impact of the method being visible on other tools that applied by the management of these companies to make decisions. The most notable implication can viewed on ratios since ratios tend to directly interact with specific items on these balance sheets and statements. Two notable methods that have a huge impact on the ratios are accelerated depreciation method and the straight-line method.

According to Baker & Powell (2005), accelerated depreciation method as opposed to methods such as the straight line method only allows an individual to deduct more of the costs in the first years of purchase of an asset as opposed to the straight line which choses to even the costs of subtractions equally in the life of the asset. Two notable methods under the accelerated category are double declining balance method and MARCS (modified accelerated cost recovery system). Accelerated depreciation method and straight-line methods tend to be different in their view of the different financial ratios and further their impacts on financial records.

The first ratio to experience the effect of these two methods is the profit margin a financial method that is calculated using the income statement. Profit margin seeks to show the earnings that a company has made out of every dollar generated as revenue. By using the term profit margins, accountants may be referring to the net profit margin which calculated by making divisions of net profit which is also known as the net income to the total sales. Accelerated rate of depreciations often leads to arise in the depreciation expense and expense often tends to affect the profits that will be made. In effect, accelerated depreciation leads to a decrease in the profit margin ratio. On the other hand, under the straight line method, ratios such as the profit margins often tend to be high in the initial years of the since the depreciation expense tends to be higher resulting to a high book value of the asset (Baker & Powell 2005).