Depreciation is meant to help paint a picture of economic reality, although sometimes its used for the opposite purpose. Heres how to tell the difference.
Imagine you purchase a $10,000 car to use in your small courier business. You expect it to last for five years—your drivers will give it a good work out—after which time it’ll be dented, bruised and ready for the crusher.
How do you account for the purchase in your books? Well, you could just recognise a $10,000 expense on the day you buy the vehicle. But why would you do that? You’re going to use this car for the next five years so it doesn’t make sense to be slugged with the entire expense in the first year you own it.
- Depreciation spreads the cost of an asset over its useful life
- It can be used to manipulate profits
- Watch out for companies that capitalise expenses
In year one, this treatment will make your profit look very poor. In the four years that follow, profit will look much better than it really is. For anyone looking at your books, that’s misleading, because accounting aims to provide a clearer picture of economic reality by way of financial information.
Instead, you it makes sense to ‘depreciate’ your purchase. On day one, your cash balance will reduce by $10,000. But rather than creating a matching expense, a new asset will be recognised on your balance sheet—your car.
In each of the next five years—the ‘useful life’ of your asset—$2,000 of depreciation will be charged against your income statement and the value of your car will be reduced by $2,000 on your balance sheet.
Depreciation at work
At the end of the five years, the cumulative result is exactly the same—$10,000 in expenses has been incurred relating to the purchase and use of your car. But, by using depreciation, the expenses more closely match its use.
That, by way of example, is depreciation at work. Simple really isn’t it?
Er, not necessarily. Sometimes, this process creates a more accurate picture of the economic reality of a business, as it does in our example. At other times it doesn’t.
As investors trying to value businesses, we must be able to recognise the distinction. Some companies use depreciation as intended—as an accurate reflection of economic reality—while others use it to boost profits by capitalising expenses (we’ll get to that in a moment).
|The precise way in which depreciation is employed varies. Some assets have longer useful lives than others (think buildings versus computers); some are depreciated based on use, rather than time; and some are depreciated using the ‘reducing balance’ method, in which depreciation is greater in early years (much like it is for a new car). But all depreciation works by employing this principle of matching expense with usage. Our example uses the ‘straight line’ method.|
When depreciation is equal to maintenance capital expenditure—the amount of money a business needs to reinvest each year to maintain its assets and competitive position—cash flow will be equal to accounting profits. When valuing a business, this makes life easy.
Let’s say your courier business has five identical $10,000 cars, each with an annual depreciation charge of $2,000, with one needing replacement each year. In this case, maintenance capital expenditure of $10,000 (for one new car every year) would be exactly equal to depreciation ($2,000 multiplied by five cars). Reported profit would thus be equal to your business’s cash flow.
|Asset||Expected benefit (years)|
|Network support infrastructure||4-52|
|Source: Telstra 2010 Annual Report|
But what if you regularly embark on big research and development projects to develop new products?
Because the research and development expenditure (R&D) may not lead to any new products, it's best to treat it as an ordinary business expense right? Not necessarily. Some companies, such as Cochlear agree: it expenses all its R&D. Software company Integrated Research, on the other hand, claims that a portion of R&D has longer term benefits, and includes this as an asset that should be amortised (see Shoptalk) over its 'useful life'.
Telstra is another example, capitalising its software expenses (see above table for Telstra's depreciation and amortisation schedule for selected assets). Such practices have the effect of making profits bigger than they should be (in general, we frown on such ‘aggressive’ accounting practices).
Conversely, accounting rules sometimes dictate that a business must recognise costs that it’s not actually incurring. Iress Market Technology is a good example.
At the heart of the company’s flagship product is an electronic financial system that was built up over many years. In the past two years, Iress has incurred about $36m of depreciation and amortisation (see Shoptalk) expenses relating to the hardware and software on which its products run. But most of that money won’t need to be spent again; over the same period of time, Iress spent only $8m or so maintaining those assets.
|Amortisation: Depreciation spreads the costs of tangible assets like cars, buildings, or machinery, over their useful lives. Amortisation does exactly the same thing, but for intangible assets such as software, capitalised development costs, or acquired client relationships.|
So Iress’s high depreciation and amortisation charges mean its reported profit actually understates its true earning power. In order to estimate Iress’s real profits, we need to adjust its reported earnings, or at least the way we measure them.
One method, used on 20 July 10 in Iress’s money making machine (Long Term Buy - $8.40), is to estimate Iress’s ongoing maintenance capital expenditure based on what it has spent in recent years. By using that figure in place of its reported depreciation and amortisation, we can generate a more accurate accounting profit.
Depreciation isn’t always adjusted downwards. Capital-intensive businesses such as Onesteel and Amcor often have maintenance capital expenditure far higher than depreciation charges. Here, we need to adjust depreciation upwards to properly estimate earning power.
In a perfect world, depreciation would always be equal to maintenance capital expenditure, and a company’s reported earnings would be ‘just right’. We hope this article has explained why it isn’t that simple, how you can spot where depreciation is being misused, and how to account for it.
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