In this chapter we learn about depreciation/amortization. These terms are properly called "amortization", but frequently the word "depreciation" is used. These terms mean the charges used to account for the wearing out or using up of certain assets; these charges are applied to earnings. These charges can be classified under the following headings:
- deprecitation (and obsolescence), replacements, renewals, or retirements
- depletion or exhaustion
- amortization of leaseholds, leasehold improvements, licenses, etc.
- amortization of patents
There is a controversy about whether to allow depreciation based on the original purchase price or the current replacement cost. Many companies that argue for replacement cost depreciation fail to mark up the replacement value for the item being depreciated, which they should. These companies vary in the way they introduce depreciation into the income account (both are designed for increasing the depreciation allowance)
over-all depreciation on replacement cost
This method is the practice of charging depreciation to the estimated increase of fixed assets to their future replacement cost.
immediate write-downs of new plant facilities
This method is the practice of charging depreciation to newly constructed fixed assets to offset the cost - this method is the polar opposite of the one above. The former writes the fixed assets up to a future value, while the latter writes down the fixed assets to a past value.
Next, we will discuss the rate of depreciation; there are several types
standard straight-line method
where a fixed annual percentage of the cost of each type of facility is deducted.
rates arbitrarily different from those tax-allowed
companies either charge less depreciation than allowed for income tax purposes, or they charge more. When less is charged, profits are boosted. When more is charged, the profits are lowered in a conservative fashion. The security analyst will need to adjust the earnings accordingly in these scenarios.
rates varying with use
This is sometimes designed for above-normal use of the facilities, but often times it is not.
Rules of thumb for dealing with the different depreciation practices
1 - amounts should not be adjusted when minor
2 - do the same for each company in the same industry
3 - strongly favor the income tax figure over a significantly different allowance adopted by the management in its reports to stockholders
4 - the security analyst should accept or develop figures differing from the income tax figure in exceptional cases where the figure will supply a better clue to the stockholder's position. Be sure that it corresponds to the value of the fixed asset.
In oil and mining companies, there are two different methods of depreciation calculating authorized, percentage depletion and discovery depletion.
In percentage depletion, the company may deduct a specific percentage of gross income for the property or 50% of the net income, whichever is lower.
In discovery depletion, the cost is marked up to a higher value established by the discovery of minerals in the property after the purchase was made, and then amortizes such value in lieu of the cost.
Oil companies can use either method, whichever makes the lower tax, but mining companies can only use the percentage depletion method.
Mining companies sometimes disclose depletion in both the income account and the balance sheet, sometimes only in the balance sheet, and sometimes in neither the income account nor the balance sheet. The stockholder should be aware of which companies deduct their depletion charges in their reported earnings and those that do not.
Oil companies depletion charges are more representative of the cost of doing business than in mining companies; mining companies will write off the cost over a number of years, but because a new oil well may use up to 80% of its total output its first year, oil companies depletion charges are more respresentative of finding new leases and new wells.
Companies are allowed to amortize the intangible assets of patents and leasehold interest; the charges can be made against surplus to avoid reducing earnings. Good-will, however, amy not be amortized for tax purposes, but is often contained in published statements; this is to show hte "purchased good-will," or the amount paid for a business in excess of its net tangible assets.