Saturday, January 20, 2007
In continuation from the topics of yesterday, we gather that one of the most important limitation of the accounting system is it is just a very rough estimation, whereby its output is as good as the inputs which in turn is dependent on how aggressive or conservative the person estimating the accounts is.
One of the subset of accounting that is very important to determining the outcome of the Income Statement is Depreciation. Depreciation is a very straight-forward component of the accounting system where it shows how clear-cut that accounting is in fact just a system of estimation, and not a precise system.
For any new car owner, they will know that once the new car is driven off the dealer's lot, the car will lose a value of anything between 10% to 30% of its original cost, in generally accepted accounting principles (GAAP), it is called depreciation. Well, in some cases, they're not actually totally in the nature of depreciation, it lies more towards the nature of devaluation. Like in this example, the very next day even if you do not drive the new car for a single mile and you want to sell it, straight away you lose a certain percentage, is that a depreciation or devaluation? So what is the difference? Depreciation is associated with wear and tear. So for a car that is as good as new which is not driven, how can it be classified as depreciation for the value that is lost? That is devaluation, a loss of value due to its relative attractiveness.
To continue on the car example, suppose you own a taxi company that consist only one taxi. Your biggest expense would be purchasing that taxi, so what is the best way to account for this expense? You could simply expense it all in a single year which will cause some very absurb scenario. For example, in the first year, if the taxi cost $30K with a scrap value of $5K at the end of the useful period, and you account all the depreciation in the first year, and also on average you can earn about 20% yearly on what you spend on the taxi, you will see a very absurb loss of $19K. And in the subsequent year, you will see a profit of about $6K till the taxi is scrapped. This manner of expensing the cost will cause wild fluctuation which distorts the actual picture from the start to the end.
What GAAP tries to do is match sales and expenses in the same time period. It does this by requiring all companies to make a few estimates on capital assets: the useful life of the asset, the salvage rate, and the depreciation rate. This way, an estimated expense can be matched with the sales the asset generates.
There are many different types of depreciation. The vast majority of companies use the straight-line depreciation method. This method, for example in the taxi company, the taxi costs $30K, it is estimated to be able to last for 10 years with a scrap or salvage value of $5K at the end of the 10 years. If we take the difference between the taxi's cost and the salvage cost, we get a total depreciation cost of $25K. Because it is estimated to last for 10 years, the annual depreciation cost is $2.5K.
So if we use the straight-line depreciation method to account for the taxi company income, it will show a better reflection of the profit that is made from year to year. In the first year to the last year assuming the return is 20% of the taxi cost, it will make a profit of $3.5K yearly for the 10 years.
And now if you compare the two methods of depreciation, clearly, you can see that the first method is a very bad reflection of any of the given year profitability although both method will give a total profit of $19K for the 10 year period of the taxi operating life span.
Also, depreciation is a tool that can be exploited. In a hypothetical example, in the low-cost airline industry, Aircock, expensive planes will make up the bulk of the company's asset, so the depreciation expense is critical to the income statement. If we go into the company financials and look under "accounting for long-lived assets," we can gather that Aircock thinks its aircraft and engines will last for between 18 to 20 years with a residue value of 15%.
Frankly, other that being a normal traveller, I'm no expert in aviation, so I can't gather much from only one airline. So in another low-cost airline, Tiga Air, in one of the footnotes stated under its "summary of significant accounting policies," it says that its aircraft will last between 20 to 22 years with a residue value of 20%.
Between the two above airlines, Tiga Air, has a slightly more aggressive accounting system, but not too much that causes a concern.
So here is another airline, Jet Black, it states its aircraft will last for between 27 to 30 years with a residue value of 25%.
So what now if you compare Jet Black with Tiga Air or Aircock? Any normal investor will probably not get into such details usually, but they would be lucky if some very cautious investor will raise the red flag. The accounting practice is much too aggressive compared to Tiga and Aircock. Although for the residue value of Jet Black of 25% seems only 5% more than Tiga Air, that is only on the surface because how could it be the residue value of a 27 to 30 year old plane be more than the residue value of planes which are 20 to 22 years ones (Tiga Air planes) or 18 to 20 years ones (Aircock).
In conclusion, depreciation expenses are meant to estimate how much "wear and tear" expense should be matched against yearly sales based on how much was paid on the asset, how much the company thinks the asset might sell for when they scrap it, and how long the company thinks the asset will last. Ultimately, you should take a look at what assumptions a company is making, go to the footnotes. That's where the story is told. If you see things that you cannot understand or are made to look complicated, it is most likely that the person telling the story does not want you to understand. So why does someone not want you to understand? It could be more than meets the eye.