One of the most common statements about new cars is that they depreciate 10%-30% once they're driven off the dealer's lot. This statement, at least according to generally accepted accounting principles (GAAP), is false. Instead of depreciation, what happens after a car is driven off a lot is devaluation.
What's the difference? Think of depreciation as wear and tear; unless you immediately crash, the car's still as good as new once it's driven off the lot. When you buy a car, you can expect to drive it for a number of years -- either until it breaks down, or until you decide to get a new one and sell off or trade in your old one.
To continue the car example: Suppose you own a taxi company consisting of only one car. Your biggest expense would be purchasing the car itself, so what would be the best way to account for this expense? You could simply expense any cash outflows, but this could result in some absurd scenarios -- for example, if you paid for the car upfront in cash, this would result in a huge loss the first year for the $15,000-$25,000 you spend on the car, but would result in wildly profitable years afterward, because the entire car's purchase price will already have been expensed.
What GAAP tries to do is match sales and expenses in the same time period. It does this by requiring companies to make a few estimates on capital assets: the useful life of the asset, the salvage rate, and the depreciation rate. This way, an estimated expense can be matched with the sales the asset generates.
There are many different types of depreciation techniques, but the vast majority of companies use the simple straight-line depreciation method. Using this method, let's say our taxi company pays $15,000 for a taxi, thinks it can use the car for 10 years, and thinks it can sell the car for $5,000 (salvage value) at the end of 10 years (its useful life). If we take the difference between the car's cost and the salvage value ($15,000 - $5,000), we get the depreciable basis ($10,000). Because we think the car's useful life is 10 years, we simply expense a tenth of the depreciable basis every year, or $1,000 ((15,000 - 5,000)/10).
Here are some examples of how companies account for depreciation expenses. For low-cost airline Southwest (NYSE: LUV ) , expensive planes make up the bulk of the company's assets, so the depreciation expense is critical to the income statement. If we go into the company's 10-K and look under "accounting for long-lived assets," we can see that Southwest thinks its aircraft and engines will last for 23-25 years, and that it thinks it can sell these assets for 15% of whatever it paid (the salvage value).
Other than being a frequent flyer, I'm no expert on planes, so I'll compare these estimates with those of JetBlue (Nasdaq: JBLU ) . Once again, if I look in JetBlue's 10-K under the "summary of significant accounting policies" footnote, I can see that JetBlue thinks its aircraft will last 25 years, and estimates a 20% residual value -- which is slightly more aggressive than Southwest, but not so much that it raises an immediate red flag.
Depreciation expenses are meant to estimate how much "wear and tear" expense should be matched against yearly sales based on how much was paid for the asset, how much the company thinks the asset might sell for, and how long the company thinks the asset will last. And to take a look at what assumptions a company is making, go to the footnotes. That's where the story is told.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. JetBlue is a Stock Advisor pick. The Motley Fool has a disclosure policy.