# Understanding depreciation



## viciam (28 March 2012)

Hi all,

I was wondering if someone can help me understand depreciation when analysing financial statement.

I've taken this from an annual report of a company I am using to teach myself, it's just a random company I picked up for no reason.







This company uses the straight line depreciation method, but I'm all at sea and I don't what to make of it and how to interpret the information that's on here?

Thanks in advance to anyone who can help


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## skc (28 March 2012)

viciam said:


> Hi all,
> 
> I was wondering if someone can help me understand depreciation when analysing financial statement.
> 
> ...




Look at the Plant and Equipment:

Cost = cost of acquisition. So at the start of the year the company has spent $2,649 on P&E. During the course of the year they spend an additional $11. This brings the balance to $2,660 at the end of the year. 

At the start of the year, the accumulated depreciation (i.e. depreciation tallyed up from all previous years on the $2,649 P&E above) was $2,475. Note this $2,475 is ~93.4% of the total cost of acquisition, which means most of these equipments are close to the end of their "depreciable" life. For the year, additional $70 was "charged" (i.e. depreciated) taking the balance to $2,545 at the end of the year.

So the net book amount at start is simply $2649 - $2475 = $115, and end of the year is $2660-$25445 = $174.

Remember depreciation is an attempt by accountants to match the use of a company's asset to a company's revenue. That's why the term "charged" is used as revenue is earned by making a charge on the company's asset on the book. 

Depending on the nature of the asset and the depreciation method, the net book value may or may not reflect the true value of the asset. For example, you may depreciate land using straight line method over say 25 years. But after 25 years your land is probably very valuable, yet on the balance it has $0 value. On the other hand, you may depreciate your software over 3 years but you find that it becomes out of date in 18 months. In that case you will do a write off of the remaining book value and take non-cash hit to the P&L.


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## viciam (29 March 2012)

Thanks for explaining that to me.

So the fundamental that I can take from this is that I can expect more capital expenditures in 2 to 3 years when this company will buying new plants and equipment?

What other fundamentals can I take away? 

Is there anyway of telling of there are any shady financial reportings going on here to enhance the income statement and improve the balance sheet?

As an investor, what should I be interpreting from these numbers?

Once again, thank you for replying


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## McLovin (29 March 2012)

viciam said:


> Thanks for explaining that to me.
> 
> So the fundamental that I can take from this is that I can expect more capital expenditures in 2 to 3 years when this company will buying new plants and equipment?




Too many variables to draw that conclusion. As skc says, it depends on whether the P&E is actually worn out when it's depreciated to zero. Buildings will often have a useful life that is longer than the depreciation schedule allows for (land is never depreciated).




viciam said:


> Is there anyway of telling of there are any shady financial reportings going on here to enhance the income statement and improve the balance sheet?




If the purchases of PP&E (found in the cashflow statement) are consistently higher than the depreciation charge that _could_ mean management are not depreciating assets fast enough. To use cash flow though you need to look at at least 7 years, IMO. You do need to allow for variables like growth etc. The other way of testing to see if it's valid is to have a look at other companies in the same industry. You would expect, for example, that all airlines would more or less depreciate their assets over the same time period. If XYZ airline depreciates over 20 years and everyone else depreciates over 15 years then you would need to investigate why that is the case.

At the end of the day you're trying to work out how much cash is left over after the business has paid for it's running costs, it's free cash flow. Depreciation is an accouting method to match revenues with expenses. Purchases of PP&E will often be lumpy but over a long time 7+ years depreciation and PP&E should be at least similar.

Also note that depreciation is based on historical cost, not replacement cost. If a company has owned a building for 25 years it is depreciating it at whatever the cost of the building was in 1987. When it comes time to replace the building it will be at 2012 prices.

ETA: You'll also find it pretty rare that a company will use accelerated depreciation method for financial reporting. It would seriously skew the P&L.


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## viciam (29 March 2012)

Its quite a difficult topic to get my head around, 

Does being able to interpret depreciation play a major part when analysing a business for an investment decision?


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## craft (29 March 2012)

viciam said:


> Is there anyway of telling of there are any shady financial reportings going on here to enhance the income statement and improve the balance sheet?




Deferred tax liabilities/assets. Any difference between how they account to their shareholders and how they account to comply with tax legislation will show up here. Normally note 4 in the annual accounts and always interesting reading.


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## skc (29 March 2012)

viciam said:


> Thanks for explaining that to me.
> 
> So the fundamental that I can take from this is that I can expect more capital expenditures in 2 to 3 years when this company will buying new plants and equipment?
> 
> ...




You have really good answer there from McLovin. 

Without knowing the industry of the particular balance sheet in question, the only conclusion I can see is that the business hasn't really acquiring P&E, and that most of the P&E should be fairly old with respect to the depreciating period.

If I had to guess , the fact that they've moved land and building to "available for sale" suggests to me that the business might be in winddown mode. But there's certainly not enough information to say something dodgy going on.


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## viciam (29 March 2012)

craft said:


> Deferred tax liabilities/assets. Any difference between how they account to their shareholders and how they account to comply with tax legislation will show up here. Normally note 4 in the annual accounts and always interesting reading.




Im sorry Im not sure im with u

Do u mean one moment they are reporting in accordance with gaap and another time using ifrs?


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## craft (29 March 2012)

viciam said:


> Its quite a difficult topic to get my head around,
> 
> Does being able to interpret depreciation play a major part when analysing a business for an investment decision?




Depreciation is one of the ways of understanding capital intensity and for me capital intensity is one of the most important underlying economic drivers that I want to understand to make an investment decision.



viciam said:


> Im sorry Im not sure im with u
> 
> Do u mean one moment they are reporting in accordance with gaap and another time using ifrs?




The difference between GAAP and the tax legislation.

Companies will normally be able to find more liberties under GAAP then they can under the tax legislation.


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## McLovin (29 March 2012)

craft said:


> Deferred tax liabilities/assets. Any difference between how they account to their shareholders and how they account to comply with tax legislation will show up here. Normally note 4 in the annual accounts and always interesting reading.




On the specific topic of depreciation though, it would be fair to say that in most instances tax legislation is more generous than GAAP (allowing for quicker depreciation) creating more temporary differences and hence DTL's.

I'd be interested in hearing how you approach sorting the legit differences from the fudged ones? It's always one I've struggled with.


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## McLovin (29 March 2012)

viciam said:


> Does being able to interpret depreciation play a major part when analysing a business for an investment decision?




Depends on the business. Some companies are have very little capital equipment and so for them depreciation and CAPEX is not a major issue. For others, manufacturers, airlines, mining companies, they rely heavily on machinery to produce their good or service. In those instances understanding the depreciation charge and CAPEX is an integral part of understanding the business.


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## craft (29 March 2012)

McLovin said:


> On the specific topic of depreciation though, it would be fair to say that in most instances tax legislation is more generous than GAAP (allowing for quicker depreciation) creating more temporary differences and hence DTL's.
> 
> I'd be interested in hearing how you approach sorting the legit differences from the fudged ones? It's always one I've struggled with.




That scenario would actually give rise to a deferred tax asset ratter then a liability wouldn’t it? It also flags for you the potential for under depreciation, hence overstatement of profits in the short term. I would expect in this case management would explain the lower depreciation rate chosen for GAAP. It may be legit and if so why not explain it.  

If it isn't explained in the notes I assume the worse unless I can prove otherwise. The fudged ones are never explained.


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## craft (29 March 2012)

craft said:


> That scenario would actually give rise to a deferred tax asset ratter then a liability wouldn’t it?




Too late to edit. Ignore that line.


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## McLovin (29 March 2012)

craft said:


> Too late to edit. Ignore that line.




Done...


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## Ves (29 March 2012)

craft said:


> Too late to edit. Ignore that line.



Ah, deferred tax items. That module at university was a pain in the ****, I remember most people still got the debits and credits around the wrong way in the exam. I happily passed, but not before making an idiot of myself once or twice in the class discussions!


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## McLovin (29 March 2012)

Ves said:


> Ah, deferred tax items. That module at university was a pain in the ****, I remember most people still got the debits and credits around the wrong way in the exam. I happily passed, but not before making an idiot of myself once or twice in the class discussions!




Accounting for business combos was my nemesis. Trying to untangle accounts for consolidation didn't work with my brain. I passed but it was my worst subject. Had a fail rate of 45%, iirc.


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## Ves (29 March 2012)

McLovin said:


> Accounting for business combos was my nemesis. Trying to untangle accounts for consolidation didn't work with my brain. I passed but it was my worst subject. Had a fail rate of 45%, iirc.



 Pretty sure that was the module I meant actually. It certainly had the DTAs and DTLs in there. 

I actually achieved a high distinction for that module. But it was a fairly steep learning curve at the beginning; any wonder the failure rate is / was so high.


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## McLovin (29 March 2012)

Ves said:


> Pretty sure that was the module I meant actually. It certainly had the DTAs and DTLs in there.




You're absolutely right, now that I think about it. I had this guy and girl (she was a Swedish exchange student and yes she was ridiculously hot) that I used to study with, we were both doing similar subjects etc and the guy used to never get below a 95 and I remember he got 66.


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## viciam (30 March 2012)

Guys I'm still not understanding how to interpret depreciation

What should be a warning to not invest in a business when looking at depreciation? and what should be a thumbs up? 

Thanks


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## McLovin (30 March 2012)

You've been given some pretty good answers, I'm not sure what else you are looking for? There's no magic formula, it's subjective.


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