There are several methods of calculating depreciation of fixed assets, but all of them can be reduced to one of two common methods, straight line and declining balance. No fixed asset lasts forever, and every one has what is referred to as a useful economic life. The IRS maintains guidelines indicating acceptable terms in years of the useful life of any fixed asset of a business. A computer may have a useful life of three years, but a building may have a useful life of 25 or 30 years. Depreciation is based on the assumption that all fixed assets decline in value over time. Though real property may increase in market value over time, facilities housing business activities suffer wear and occasionally need maintenance or restoration that can be quite costly. Depreciation of fixed assets provides a means of accounting for businesses’ consumption of those fixed assets over the course of their useful life.

In the straight line method, depreciation charge is calculated on the basis of equal amounts of value being depreciated each year of the fixed asset’s useful life. The straight line depreciation equation is:

D = (C- R)/ N

Where D = depreciation
C = original cost of the fixed asset
R = the fixed asset’s residual value
N = the number of years of the fixed asset’s useful economic life.

Thus a fixed asset that costs $17,000, has a useful economic life of five years and can be sold at the end of those five years for a residual value of $2,000 provides $3,000 in depreciation for each of the five years of its useful life. The equation reads ($17,000 – $2,000) / 5 years = $3,000 each year.

The declining balance method of depreciating fixed assets often is referred to as the double declining balance method. It allows the business to take a double depreciation charge in the first year. The book value of the asset then is reduced by the amount of the depreciation charge. That resulting book value is subject to the same double percentage the following year and each year of the fixed asset’s useful life.

The total amount allowed in depreciation is the same with both methods. The primary difference is that the declining balance method allows the business to take the greatest depreciation charge in the first year of the asset’s use. The straight line method is simpler, but may not always yield any first year advantages for the organization. Whichever method the organization chooses to use to depreciate fixed assets, that method should be used for the entire terms of the fixed asset’s useful life.

GAAP is the abbreviation of Generally Accepted Accounting Principles. GAAP is not necessarily a collection of rules and guidelines, though GAAP uses those. Rather, GAAP represents a collection of broad concepts and detailed practices that represent best accounting practices as it is accepted at a given time, and often within a specific industry.

Reporting according to GAAP provides a measure of uniformity so that those examining financial statements have a foundation from which to compare performance to another period or another company, or develop financial ratios that use specific GAAP-defined quantities.

Even though there is no overseeing authority, GAAP depends on a rule of four in terms of key assumptions, basic principles and basic constraints. There are four of each.

Key Assumptions About GAAP

The first key assumption comprising GAAP is that the business entity is separate and distinct from all others. This means that all of the figures shown in the organization’s financial reports are specific only to that organization, that no other separate business entity is obligated to contribute to the organization or can lay claim to the business’ bottom line revenues.

The second key assumption is that the business is a going concern, and will be for the foreseeable future. That length of foreseeable future is at least one year.

A third key assumption is that amounts listed in the organization’s financial statements are stated in terms of a stable currency. All amounts are listed in the same currency, meaning that an international company cannot report results in a combination of dollars, euros, dinars, sterling or any currencies used in the countries in which the company operates.

The organization can choose to report in any currency it chooses – unless it is a public company reporting for American investors – but the currency has to be used consistently throughout the financial report.

The final key assumption is that the time period stated in financial reporting is accurate. If the time period is identified as including January 1 through December 31 of a single year, then GAAP dictates that all transactions included in the report did indeed occur within the identified time period.

Four Basic Principles

GAAP’s four basic principles address the matters of costs, revenues, matching and disclosure. The cost principle refers to the fact that all listed values are accurate and reflect only actual costs, rather than any market value of the cost items. The revenue principle of GAAP is that revenue is reported when it is recognized.

Times of revenue recognition can vary depending on whether the organization uses the cash or accrual method of accounting, but the GAAP principle is that it will be recognized in a timely manner.

The matching GAAP principle matches revenues with expenses. This means that the expenses of a revenue producing activity are reported when the item is sold, rather than when the organization receives payment for it or when it issues an invoice for it.

The disclosure principle associated with GAAP requires that information anyone assessing the organization’s financial standing would need is included in the reporting of the organization’s financial status.

Four Constraints

The four basic constraints associated with GAAP include objectivity, materiality, consistency and prudence. Objectivity includes issues such as auditor independence and that information is verifiable. Materiality refers to the completeness of information included in financial reporting and whether information would be valuable to outside parties.

Consistency requires that the organization uses the same accounting methods from year to year. If it chooses to change accounting methods, then it must make that statement in its financial reporting statements. Prudence requires that auditors and accountants choose methods that minimize the possibility of overstating either assets or income.

None of the four types of financial statements can be used on its own to arrive at a sound investment decision, but the four together serve to provide an array of information for lenders, investors or potential investors. The bottom line figure of the income statement, net income, becomes a prominent entry on the statement of retained earnings, which in turn becomes an entry on the organization’s balance sheet. Similarly, the bottom line on the statement of cash flows – cash at the end of the period – becomes the leading entry on the balance sheet. Most of these four basic financial statements are necessary to derive various financial ratios, each of which can supply specific information.

There are many standard financial ratios, each of which has its own usefulness. Some of are greater interest to management, some are favored by investors. Some speak to profitability, while others are more useful in assessing management’s effectiveness.

Some of the most common financial ratios and their derivation are:

• Earnings per share – EPS: 12 months earnings divided by number of shares
• Price/Earnings – P/E: Share price divided by earnings per share
• Price-Earnings-Growth – PEG: Price/earnings ratio divided by earnings growth rate
• Price/Sales: Market capitalization divided by total revenue
• Total Debt/Equity: Liabilities divided by total value of stock
• Current Ratio: Current assets divided by current liabilities
• Quick Ratio: (cash plus receivables) divided by current liabilities
• Current Inventory Turnover: Cost of Goods Sold divided by average inventory
• Return on Assets (ROA): Earnings before income taxes (EBIT) divided by average total assets
• Return on Equity (ROE): net income divided by stockholders’ equity
• Operating Profit Margin: EBIT divided by sales
• Net Profit Margin: Earnings after taxes divided by sales

Two Ratio Classes

Profitability

There are four profitability ratios, each of which provides specific information for the investor and for the company’s management. The profitability ratios are operating profit margin, net profit margin, return on assets and return on equity. Operating and net profit margins provide management with measures of how well the company is doing what it intends to do. Investors may be interested in these ratios, but they likely have greater interest in ROE, which provides an indication of how much the company is generating in earnings per invested dollar. This is of direct interest to shareholders, while ROA is of greater use to the company’s senior management.

Liquidity Measures

Another four ratios are designed to indicate the organization’s ability to meet its short-term obligations such as interest payments and other short term debts, which typically are paid for with current assets. These ratios are the current ratio, quick ratio, working capital and leverage. The current ratio results from dividing current assets by current liabilities. In most industries, a current ratio approaching one is most desirable. A lower value can indicate that a company may be having difficulties meeting its short-term obligations, while a current ratio value higher than one can be indicative of poor or inefficient use of funds. Optimal current ratio values vary among industries, however.

Also known as the acid test, the quick ratio is similar to the current ratio. The difference between the two is that the quick ratio excludes inventory, making it a more conservative test than the current ratio. The quick ratio is a better measure in industries where inventory cannot be quickly converted to cash.

Working capital is not a ratio at all, but rather is an equation of current assets minus current liabilities. The measure of working capital provides some measure of security for the investor, in that the investor can see that if the figure is positive, then the company has an effective “security blanket” it can use to meet its obligations.

When a company has insufficient liquidity, it may be over leveraged. Leverage is the ratio that measures the organization’s capital structure, and is derived by dividing long term debt by total equity. This is of direct interest to investors because it can reveal how the organization finances its assets. Whether the organization uses all equity or a combination of debt and equity is of direct importance to the investor. The organization with a lower debt load faces less risk in times of downturn.