Mastering Depreciation in Financial Models: Methods, Tax Implications and Common Pitfalls

This article summarises insights from the Forvis Mazars webinar: Mastering Depreciation and Avoiding Modeling Pitfalls. Presented by Leigh Tomlinson (Director, EMEA Financial Modelling Training) and Keshav Rana (Manager, EMEA Financial Modelling Training).

Leigh Tomlinson

Keshav Rana

Depreciation is one of those concepts that appears straightforward until you start modelling it. In project finance, getting it wrong can affect everything from your tax calculations and CFADS through to debt sizing and investor returns. Yet it remains one of the most common sources of errors in financial models, particularly when accounting and tax depreciation are treated as the same thing, or when ongoing additions are not handled correctly.

When Forvis Mazars ran a live poll during this webinar, the vast majority of participants correctly identified that depreciation is about allocating an asset’s cost over its useful life. But as the session revealed, knowing the definition and modelling it correctly in practice are two very different things.

What is depreciation and why does it matter in project finance models?

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 be misleading. A $100 million wind farm built in one year generates revenue for 20 years. Depreciation spreads that 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.”

Leigh Tomlinson

For a cost to be capitalised on the balance sheet rather than expensed immediately, it must bring future economic benefits, the cost 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, with the charge flowing through the profit and loss statement as a non-cash expense.

That non-cash distinction is important. Depreciation does not appear directly in the cash flow statement. But as the webinar explored in detail, it has significant indirect effects on cash flow, debt sizing and investor returns that modellers cannot afford to overlook.

Accounting depreciation versus tax depreciation in financial models

One of the most critical distinctions in financial modelling is between accounting depreciation and tax depreciation. They serve different purposes, follow different rules, and are calculated using different methods. In many models, they require entirely separate calculation sections.

Accounting depreciation, sometimes called book depreciation, is governed by accounting standards such as IFRS and GAAP. The method is chosen by management and the aim is to match the cost of the asset with the revenue it generates over its useful life. Common methods include straight line, reducing balance, units of production and sum of the years’ digits.

Tax depreciation, by contrast, is dictated by the relevant tax authority. In the UK this 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 referred to as capital allowances. The purpose is to determine the depreciation deduction allowable for tax purposes, ensuring consistency between the tax calculation at the regulatory end and at the project level.

“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.”

Leigh Tomlinson

The reason the two methods must be modelled separately is that tax depreciation directly affects your tax calculation. You start with EBIT, which includes accounting depreciation, add back the accounting depreciation, and deduct the tax depreciation to arrive at taxable income. If you skip this adjustment, your tax calculation will be incorrect, and that flows through to every downstream metric.

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 in the initial periods 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.”

Keshav Rana

Over the life of the project, the total tax paid is the same. But paying less tax earlier improves the project’s economics, making it more attractive to investors.

This has a direct chain of effects in a project finance model. Tax depreciation affects the tax calculation. The tax calculation affects cash flow available for debt service (CFADS), because tax is a component of CFADS. If CFADS changes, so does the project’s ability to service and size debt, particularly when sizing to a target DSCR. A change in debt sizing then affects leverage, which in turn affects equity investment and investor returns.

For a detailed walkthrough of how these cash flow mechanics connect, our tutorials on features of a cash flow waterfall in project finance and debt sculpting to target DSCR without VBA cover the layered logic involved.

Straight line depreciation method: how to model it correctly

The straight line method is the most common approach for accounting depreciation. As the name suggests, it produces equal depreciation charges in each period. The formula is the asset base multiplied by the depreciation rate, where the rate is calculated as one divided by the useful life.

In the webinar’s Excel demonstration, the team built a straight line depreciation calculation using a corkscrew account with opening balance, movements, and closing balance. The key modelling principles demonstrated were:

• Keep the formula simple. The depreciation charge is the product of just three elements: the asset base, the depreciation rate, and a binary flag controlling whether depreciation is active in that period. Using flags to control timing avoids depreciation being calculated during the construction period, which is a common error.

“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.”

Leigh Tomlinson

• Use helper columns. Clearly labelling the rate and the base in helper columns to the left of the timeline makes the formula transparent and easy to audit. Anyone reviewing the model can immediately see what rate is being applied and to what base.
• Always check the output. When the team first entered the formula without the depreciation flag, depreciation appeared during construction. Reviewing the output immediately caught the error. As a further check, the total depreciation should equal the total capex additions, confirming that the asset has been fully depreciated over its useful life.
• Handle the write-off at end of project life. If the project ends before the asset’s useful life is complete, or if ongoing maintenance capex has been added late in the project, there will be a residual balance. This must be written off in the final period using an end-of-operations flag. If there is a salvage or residual value, the closing balance should match that value rather than going to zero.

Reducing balance depreciation method: modelling for tax depreciation

The reducing balance method applies the depreciation rate to the opening balance each period rather than to a fixed base. This produces higher depreciation charges in earlier periods that decrease over time, which is why it is commonly used for tax depreciation where governments want to incentivise early investment.

A critical modelling consideration is the rate adjustment for sub-annual periods. If your model runs on a quarterly timeline and you have an annual reducing balance rate of 35%, you cannot simply divide by four. Because the reducing balance method compounds, you need to decompound the rate using the formula: 1 minus (1 minus the annual rate) to the power of (1 divided by the number of periods per year). Dividing by four will produce an incorrect result.

The other characteristic to be aware of is that mathematically, a reducing balance calculation never reaches zero. As Leigh Tomlinson noted, materially it might be a very small amount, but mathematically it is impossible, because you are always taking a percentage of something. This is one reason the method is not typically used for accounting depreciation, where the objective is to recognise the full cost of the asset. The write-off mechanism at the end of the project handles the residual amount.

How depreciation flows through your financial statements

Understanding where depreciation appears in the financial statements, and where it does not, is essential for building a model that balances correctly.

Accounting depreciation reduces EBIT on the profit and loss statement, which flows through to reduce 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 has an indirect impact on distributions. Dividends are typically constrained by retained earnings and retained cash. If accounting depreciation reduces retained earnings, it can delay or reduce distributions to equity investors, creating trapped cash.

“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.”

Leigh Tomlinson

Tax depreciation does not appear in the P&L or balance sheet directly. Its impact comes through the tax calculation, which affects CFADS and therefore debt sizing, leverage, equity requirements and investor returns. The webinar also noted that where accounting and tax depreciation methods differ, the temporary timing differences create deferred tax assets or deferred tax liabilities on the balance sheet.

Common depreciation modelling errors to avoid

The webinar highlighted several errors that the Forvis Mazars team regularly encounters when reviewing financial models.

• Depreciating during construction. The asset should only begin depreciating once it is operational. Using a binary operations flag in the formula prevents this.
• Missing ongoing additions. Maintenance capex spent during the operations phase must also be depreciated. Forgetting to include it in the asset base is a common oversight that will cause the balance sheet to break.

“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.”

Keshav Rana

• Applying the wrong tax depreciation rules. Tax rates, methods and eligible asset categories vary by country and by asset class. Even within the same country, different projects may be subject to different rules. As the webinar repeatedly emphasised, 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 incorrect. The decompounding formula must be used.
• Failing to write off the residual balance. Whether using straight line with ongoing additions or reducing balance, a write-off mechanism at the end of the project is necessary to close the asset account correctly.
• Not stress testing the impact. Switching depreciation assumptions on and off to observe the effect on CFADS, debt sizing, and returns is a valuable exercise that helps modellers understand the sensitivity of their outputs to these inputs.

For modellers looking to build these skills further, the cash sweep analysis and DSRA tutorials demonstrate related mechanics that interact with the depreciation calculations described above.

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To explore depreciation modelling and other advanced techniques in a hands-on setting, Forvis Mazars offers a range of financial modelling training courses. Our best practice project finance modelling course covers financial statement construction, and our advanced project finance modelling course goes deeper into topics like ongoing additions, tax depreciation mechanics and debt sizing.