This article summarises our webinar Mastering depreciation and avoiding modelling pitfalls, presented by Leigh Tomlinson and Keshav Rana of our EMEA financial modelling training team.
Depreciation looks simple until you model it. In project finance, getting it wrong can affect everything from the tax calculation and CFADS to debt sizing and investor returns. It remains one of the most common sources of error in financial models, particularly when accounting and tax depreciation are treated as the same thing, or when ongoing additions are not handled correctly.
When we ran a live poll during the webinar, most participants correctly said that depreciation allocates an asset’s cost over its useful life. As the session showed, knowing the definition and modelling it correctly are two very different things.
What depreciation does in a project finance model
At its core, depreciation is about matching. When a project incurs a large capital expenditure, recognising the full cost as an expense in the period it is incurred would mislead. A wind farm built in one year generates revenue for 20 years. Depreciation spreads the cost across the periods in which the asset delivers economic benefit.
“If you think of a very simple example, you’re building out a wind farm and say that costs $100 million. What you don’t want to recognise is a $100 million expense in that year of construction. It’s really unfair to recognise that and create a loss on your P&L. You capitalise that cost, recognise it on your balance sheet, and then spread the expense over the life of the asset.”
For a cost to be capitalised on the balance sheet instead of expensed straight away, it must bring future economic benefits, it must be measurable and the asset must have a useful life of more than one year. Once capitalised, the asset is depreciated over that useful life, and the charge flows through the profit and loss statement as a non-cash expense.
That non-cash point matters. Depreciation does not appear directly in the cash flow statement, but it has large indirect effects on cash flow, debt sizing and investor returns that modellers cannot afford to overlook.
Accounting depreciation and tax depreciation
Accounting depreciation and tax depreciation serve different purposes, follow different rules and use different methods. In many models they need entirely separate calculation sections.
Accounting depreciation, sometimes called book depreciation, is governed by accounting standards such as IFRS and GAAP. Management chooses the method, and the aim is to match the cost of the asset with the revenue it generates over its useful life. Common methods are straight line, reducing balance, units of production and sum of the years’ digits.
Tax depreciation is set by the tax authority. In the UK it is HMRC, where it is known as capital allowances. In the US it falls under the IRS and the Modified Accelerated Cost Recovery System (MACRS). In Australia it is also called capital allowances. Its purpose is to set the depreciation deduction allowed for tax, so the tax calculation in the model matches the one the authority will apply.
“Tax rules are very specific for certain countries. Even in the same country, the rules could vary depending on what project you’re looking at. I can’t highlight enough how important it is to be getting good tax advice here.”
The two have to be modelled separately because tax depreciation drives the tax calculation. You start with EBIT, which includes accounting depreciation, add back the accounting depreciation and deduct the tax depreciation to reach taxable income. Skip this adjustment and the tax calculation is wrong, and so is every metric downstream of it.
How tax depreciation affects CFADS and debt sizing
Governments often allow accelerated tax depreciation in the early years of a project as an incentive. Higher depreciation early on means lower taxable income and lower tax payments, which increases early cash flows.
“This is not a tax-saving mechanism. Surely you save some taxes in the initial years, but later on, during the life of your project, you are going to pay more taxes. Overall you pay the same kinds of taxes, but the time value of money kicks in. If you pay less taxes in the initial year, that increases your NPV and IRR.”
Over the life of the project the total tax paid is the same. Paying less tax earlier improves the project’s economics, which makes it more attractive to investors.
In a project finance model this sets off a chain of effects. Tax depreciation affects the tax calculation. Tax is a component of cash flow available for debt service (CFADS), so CFADS changes too. If CFADS changes, so does the project’s ability to service and size debt, particularly when debt is sized to a target DSCR. A change in debt sizing then changes leverage, which changes the equity investment and investor returns.
Our tutorials on the features of a cash flow waterfall in project finance and debt sculpting to a target DSCR without VBA walk through how these cash flow mechanics connect.
How to model the straight line method
The straight line method is the most common approach for accounting depreciation. It gives an equal charge in each period: the asset base multiplied by the depreciation rate, where the rate is one divided by the useful life.
In the webinar’s Excel demonstration, the team built a straight line calculation in a corkscrew account with an opening balance, movements and a closing balance. The modelling principles were:
- Keep the formula simple. The charge is the product of three elements: the asset base, the depreciation rate and a flag that says whether depreciation applies in the period. The flag stops depreciation being calculated during construction, a common error.
- Use helper columns. Label the rate and the base in helper columns to the left of the timeline, so anyone reviewing the model can see at once what rate applies to what base.
- Always check the output. When the team first entered the formula without the flag, depreciation appeared during construction, and a look at the output caught it straight away. As a further check, total depreciation should equal total capex additions.
- Write off the balance at the end of the project. If the project ends before the asset’s useful life does, or maintenance capex is added late, a residual balance remains. Write it off in the final period with an end-of-operations flag. If there is a salvage value, the closing balance should match it instead of reaching zero.
“What you’re looking at here is a very simple formula. You’re looking at the product of just three numbers: the asset base, the depreciation rate, and a flag that says, is this the period of depreciation? The risk of this formula being entered wrong is reduced because we’re keeping it very simple. It’s also very accessible.”
Modelling tax depreciation with the reducing balance method
The reducing balance method applies the depreciation rate to the opening balance in each period, not to a fixed base. Charges are higher early on and fall over time, which is why governments that want to encourage early investment often use it for tax depreciation.
Sub-annual periods need a rate adjustment. If your model runs quarterly and the annual reducing balance rate is 35%, you cannot simply divide by four. Because the method compounds, you decompound the rate: 1 minus (1 minus the annual rate) to the power of (1 divided by the number of periods in a year). Dividing by four gives the wrong result.
Mathematically, a reducing balance calculation never reaches zero. As Leigh Tomlinson put it, the amount left may be immaterial, but you are always taking a percentage of something. That is one reason the method is rarely used for accounting depreciation, where the aim is to recognise the full cost of the asset. The write-off at the end of the project deals with the residual amount.
How depreciation flows through the financial statements
Knowing where depreciation appears in the financial statements, and where it does not, is essential for a model that balances.
Accounting depreciation reduces EBIT in the profit and loss statement, which reduces net profit after tax and retained earnings. On the balance sheet it reduces the fixed asset (PP&E) balance. It does not appear directly in the cash flow statement, but it affects distributions. Dividends are usually limited by retained earnings and retained cash, so if accounting depreciation reduces retained earnings it can delay or reduce distributions and trap cash in the project.
“People think that the accounting depreciation just hits the P&L and doesn’t really affect the cash flow. But when you think about it, if your return is structured around receiving dividends, that’s based around the profit reserves, and those profit reserves are affected by your depreciation. This can actually have an indirect impact on your cash flow.”
Tax depreciation does not appear directly in the profit and loss statement or the balance sheet. It acts through the tax calculation, which affects CFADS and so debt sizing, leverage, the equity requirement and investor returns. Where the accounting and tax methods differ, the timing differences create deferred tax assets or liabilities on the balance sheet.
Common depreciation errors to avoid
The webinar set out the errors our team finds most often when reviewing financial models.
- Depreciating during construction. The asset should start depreciating only once it is operational. An operations flag in the formula prevents the error.
- Missing ongoing additions. Maintenance capex spent during operations must be depreciated too. Leaving it out of the asset base is a common oversight that breaks the balance sheet.
- Applying the wrong tax depreciation rules. Rates, methods and eligible asset categories vary by country and asset class, and even between projects in the same country. Specialist tax advice is essential.
- Not adjusting the reducing balance rate for sub-annual periods. Dividing an annual rate by four for a quarterly model is wrong. Use the decompounding formula.
- Not writing off the residual balance. Straight line with ongoing additions and reducing balance both need a write-off at the end of the project to close the asset account.
- Not stress testing the effect. Switch the depreciation assumptions on and off and watch what happens to CFADS, debt sizing and returns, so you understand how sensitive the outputs are to these inputs.
“If your tax depreciation gets changed, your CFADS will be impacted, because tax is a component for your CFADS. And based on CFADS, you can do your debt sizing. That’s how your debt sizing gets impacted by the tax depreciation.”
Our cash sweep analysis and DSRA tutorials show related mechanics that interact with these depreciation calculations. The Best Practice Project Finance Modelling course covers building the financial statements, and Advanced Project Finance Modelling goes further into ongoing additions, tax depreciation and debt sizing.
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