FINANCIAL ACCOUNTING
FALL 2025
SESSION 6 DEPRECIATION
FELIX VETTER, JOSEPH WEBER, CHLOE XIE
MIT SLOAN SCHOOL OF MANAGEMENT
ANNOUNCEMENTS
2
LEARNING OBJECTIVES
1.
Fixed asset accounting also involves estimates that can have large effects on the financial
statement. We want you to understand what those estimates are and how they effect the
financials.
2.
Fixed assets are a great example of capitalizing an expense and spreading the costs out over
an assets life.
3.
Fixed assets have the potential to make up large parts of the balance sheet, so we want you to
understand the key transactions:
- Acquisition
- Depreciation
- Change in estimate
- Sale
3
HOW DO WE RECORD AN ACQUISITION?
Hertz purchases a car for $25,000, what transaction do they record?
Assets
Cash
A/R
=
Liabilities
Auto
+
Stockholders Equity
CC
Income Statement
Caption
R/E
At the time of the acquisition, the cost of a fixed asset does not enter the
income statement. Why?
When does the cost enter the income statement?
What happens when we sell the asset?
4
HOW DO WE RECORD AN ACQUISITION AND CONVERT THE
COST TO EXPENSE?
Hertz purchases equipment for $25,000. What transaction do they record?
Assets
Cash
=
A/R
Liabilities
+
Auto
Stockholders Equity
CC
Income Statement
Caption
R/E
At the end of reporting periods thereafter, what must be recorded
Assets
Cash
A/R
=
Auto
- Acc.
Depr
(XA)
Liabilities
+
Stockholders Equity
CC
Income Statement
Caption
R/E
5
GENERAL TERMINOLOGY
Cost of Asset: expenditure necessary to ready the asset for intended use, e.g. purchase
price, installation, delivery, training, etc.
Estimated Salvage (Residual) Value: predicted selling price of long-lived asset less any
removal costs at the end of useful life
Depreciable Base: Asset Cost - Salvage value
Accumulated Depreciation: the cumulative amount of depreciation expense taken over the
asset’s useful life
 A contra asset
 Typically deducted from historical cost of the asset
 Sum of past depreciation
Book value: Asset’s remaining unallocated cost  historical cost less accumulated
depreciation
6
TO ACCOUNT FOR PPE ONE MUST ANSWER THE FOLLOWING
FOUR QUESTIONS
1
What is the acquisition cost?
2
How much is the estimated salvage value?
3
What is the expected useful service life?
4
What is the depreciation pattern?
7
ESTIMATES USED IN DEPRECIATION
1
Estimating useful life:
• Requires managerial judgment
• Must decide on time period over which asset will be used
• Might not equal the physical life of the asset
2
Estimating salvage value:
• Requires managerial judgment
• Must decide on estimate of value at disposal, net of selling costs
3
What pattern of depreciation should be used?
• Straight line
• Accelerated depreciation
• Units of Production
8
GAAP DEPRECIATION METHODS
Straight-line Depreciation
 Used by overwhelming majority of US firms
 Straightforward to calculate
 Constant allocation of the cost of an asset from the balance sheet to the income
statement
Our focus of class
Accelerated Depreciation
 Mostly confined to tax reporting – we will talk about this in Class 16 on taxes
9
ESTIMATING DEPRECIATION EXPENSE
The “Straight Line Method” Depreciation expense per year =
(Acquisition Cost – Salvage Value)
Estimated Useful Life
Depreciation is a cost allocation process intended to match the asset costs with the benefits in each period
10
EFFECTS ON THE FINANCIAL STATEMENTS
What financial statements are affected by depreciation?
Income Statement: Depreciation Expense
Balance Sheet: Accumulated Depreciation
Statement of Cash Flows:
Does depreciation affect cash?
No – there will be an adjustment to income on the Indirect Statement of Cash Flows
(Discussed in Class 11)
11
EFFECTS ON THE FINANCIAL STATEMENTS
Suppose Hertz buys a car on 1/1/2006 for $20,000 cash. They plan on using the car
for 5 years, at which point its salvage value will be $5,000. How would Hertz account
for the purchase and the deprecation expense transactions?
12
DEPRECIATION CALCULATIONS (1/2)
What is the acquisition price?
1
2
3
What is the salvage value?
How much will be depreciated?
13
DEPRECIATION CALCULATIONS (2/2)
What is the useful life of the car?
4
5
What is the annual depreciation expense?
14
DEPRECIATION EXPENSE ($000S)
Contra-Asset to record reduction in PPE Values
Assets
Date
Cash
PPE
=
- Acc. Depr (XA)
Liabilities
+
Stockholders Equity
Income Statement
Caption
R/E
15
DEPRECIATION SCHEDULE ($000S)
Date
Gross PP&E
-Accum Dep
Net Book
Value
Depreciation
Expense
12/31/2006
20,000
3,000
17,000
3,000
12/31/2007
20,000
6,000
14,000
3,000
12/31/2008
20,000
9,000
11,000
3,000
12/31/2009
20,000
12,000
8,000
3,000
12/31/2010
20,000
15,000
5,000
3,000
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GAIN OR LOSS ON DISPOSAL OF PPE
Suppose Hertz sells the car (after recording deprecation expense) on 1/1/2011 for $7,000? How would you
account for that transaction?
1. Record cash or the market value of the asset received for the PPE
2. Record disposal of the asset by removing the cost of the asset from PPE
3. Reverse the accumulated depreciation associated with the asset
4. Calculate gain or loss as follows:
Cash – (Cost - AccDep) = Gain/Loss
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DISPOSAL OF THE ASSET
Assets
Date
Cash
Ending
Balance
12/31/10
=
PPE
- Acc. Depr (XA)
$20,000
$15,000
Liabilities
+
Stockholders Equity
Income Statement
Caption
R/E
18
CHANGING DEPRECIATION ESTIMATES
(NOTE: INDEPENDENT EXAMPLE; IGNORE 1/1/11 DISPOSAL EXAMPLE)
Suppose on 1/1/2007, one year after purchasing the car, Hertz decides to keep the car an extra
year (i.e. until 12/31/2011), thereby changing the car’s useful life to six years total. How would
this affect deprecation calculations?
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DEPRECIATION CALCULATIONS
1 How much is left to be depreciated?
2 What is the remaining useful life?
3
What is the new annual depreciation expense?
20
OVERVIEW: HERTZ
What is Hertz’s core business? How do they generate revenues?
How would the financial crisis and the overall economy affect Hertz’s accounting?
21
HERTZ – REVENUE GENERATING FIXED ASSETS
22
WHAT CAUSES CHANGES IN THE DEPRECIATION RATE?
Changes in (i) useful life, (ii) residual value, and/or (iii) depreciation method
Hertz discloses that the provisions for depreciation and amortization are computed on a straight-line basis
over the estimated useful lives of:
2006: Revenue Earning Equipment
Cars
5 to 16 months
Other equipment
24 to 108 months
2013: Revenue Earning Equipment
Cars
4 to 36 months
Other equipment
24 to 108 months
23
WHY WOULD HERTZ CHANGE THE USEFUL LIFE AND/OR
RESIDUAL VALUE?
1
2
3
24
DID HERTZ “COOK THE BOOKS”?
If Hertz used the 2006-2009 useful life assumptions for 2009-2013, they would have virtually no income
during this period
25
CHANGE IN RESIDUAL VALUE:
ROLE OF MACROECONOMY
Used Vehicle Value Index (“VVI”) Recall that gains & losses are calculated as follows:
Gain/Loss = (Sale Price – Net PPE)
= (Sale Price – (PPE – Acc Dep))
Suppose Hertz changed its estimated salvage value
using the “Vehicle Value Index.” What do you expect
following:
(a) VVI Downturns: Losses
(b) VVI Upturns:
Gains
26
WHY IS DEPRECIATION EXPENSE GROWING MORE SLOWLY
THAN ASSETS?
Increases in the useful life can be justified by:
- Strategic decision to use assets longer
- Acquisition of lower-priced rental chain (purchase of Dollar Thrifty in 2012)
Increases in residual values / salvage values can be justified by:
- Cash for clunkers program entirely removed several used cars from the market
- Changes in economic conditions
27
HOW DOES HERTZ COMPARE TO AVIS
2006
2007
2008
2009
2010
2011
2012
2013
Hertz Global Holdings, Inc.
Equipment (Gross)
Depreciation Expense
Deprecation Rate
10,876 11,681 10,344 10,788 11,191 12,509 15,789 17,969
1,762 1,906 2,020 1,780 1,747 1,912 2,146 2,408
16.2% 16.3% 19.5% 16.5% 15.6% 15.3% 13.6% 13.4%
Avis Budget Group, Inc.
Equipment (Gross)
Depreciation Expense
Deprecation Rate
8,042 8,496 8,383 6,912 7,557 9,614 10,619 10,993
1,362 1,565 1,639 1,391 1,277 1,395 1,438 1,678
16.9% 18.4% 19.6% 20.1% 16.9% 14.5% 13.5% 15.3%
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ULTIMATELY, IT LOOKS LIKE IT WAS FRAUD
In August 2020, 6 years after the news article was written and 4 years after we wrote the case, the
SEC charged HERTZ with fraud
Press Release (see https://www.sec.gov/news/press-release/2020-183)
SEC Charges Hertz’s Former CEO With Aiding and Abetting Company’s Financial Reporting and
Disclosure Violations
The Securities and Exchange Commission today charged former Hertz CEO and Chairman Mark Frissora
with aiding and abetting the company in its filing of inaccurate financial statements and disclosures. Frissora
has agreed to settle the charges and repay Hertz nearly $2 million in incentive-based compensation….
According to the complaint, Frissora also led Hertz to hold rental cars in its fleet for longer periods and thus
lower its depreciation expenses, without properly disclosing the change – and the risks of relying on older
vehicles – to investors.
37
CONCLUSION
Depreciation is a cost allocation process intended to match the asset costs with the benefits.
Depreciation is not a transaction that affects cash!
However, depreciation policy still affects:

Income statement (via depreciation and/or gains/losses)

Balance Sheet (via net book values of assets)

Cash flow Statement (through adjustments to gains/losses), but not cash flows
Next class: M&A and the aQuantive case
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FINANCIAL ACCOUNTING