The Value Investor's Handbook: How Management Can Game Depreciation Figures

Make sure you don't get fooled by these tricks

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Jul 17, 2020
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Accounting is governed by a set of fairly strict rules, but that doesn’t mean that corporate management teams don’t try to push the envelope.

At the end of the day, a set of accounts is just an abstraction used to summarise what is happening (and what has happened) at a company, and there is always going to be some ambiguity and discrepancy between what is reported and what is actually true.

Today, we are going to delve into the ways in which accounting for depreciation can be misleading.

The limitations of accounting

As you may already know, depreciation is a method of accounting for the wear and tear on physical assets that a business owns. Typically, it spreads out the cost of an asset over its useful lifetime. So, if an automobile manufacturer purchases a new piece of equipment for $10 million and expects it to be useful for 10 years, then it will book a $1 million depreciation charge every year to account for this. Sounds simple, right?

Unfortunately, this is where the aforementioned ambiguity comes into play. The useful lifetime of a piece of equipment is difficult to estimate, and this creates the opportunity for executives to massage their numbers. For instance, let’s take that same $10 million piece of equipment. What if instead of 10 years, its useful lifetime is taken to be 20 years? In this case, the annual depreciation charge will be $500,000.

On its own, this is not necessarily a problem. However, what if the equipment is sold after five years? Let’s assume it can be sold for $5 million. If the asset was depreciated over 10 years, then after five years the company will break even - a piece of equipment worth $5 million (after the five years of depreciation) was sold for $5 million. On the other hand, if the useful lifetime was assumed to be 20 years, then the company will book a $2.5 million loss, as the asset will be valued at $7.5 million.

This illustrates the limitations of accounting. In both cases, the same sequence of events took place: the automobile manufacturer bought an asset, held it for five years and then sold it. And yet the earnings statement will look different depending on what approach was chosen. In the case of the 10 year lifetime, earnings will look smoother compared to the 20 year lifetime.

The main takeaway here is that it’s not always enough to take financial statements at face value. Investors who have a good working knowledge of the industry they are investing in will have an advantage over those who blindly trust the numbers. If you come from an engineering background and know for a fact that that piece of automobile manufacturing equipment cannot have a useful lifetime of more than ten years, then you should immediately be skeptical of the 20 year assumption. This is why you should stay within your circle of competence - forewarned is forearmed.

Disclosure: The author owns no stocks mentioned.

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