3. Reserves: The analyst must give critical attention to the matter of reserves for depreciation and amortization, and reserves for future losses and other contingencies. These reserves are subject in good part to arbitrary determination by the management.
Depreciation represents the estimated shrinkage in the value of the fixed or capital assets, due to wearing out, to using up or to their approaching extinction for whatever cause. The important charges of this character may be classified as follows
a) Depreciation, replacements, renewals or retirements.
b) Depletion or exhaustion
c) Amortization of leaseholds, leasehold improvements, licenses, etc.
d) Amortization of patents.
The accounting theory that governs depreciation charges is simple enough. If a capital asset has a limited life, provision must be made to write off the cost of that asset by charges against earnings distributed over the period of its life. But there are several complications: First, accounting rules themselves may permit a value other than cost as the base for the amortization charge; Second, many companies fail to follow accepted accounting practice in stating their depreciation deduction in the income account; Third, there are occasions when an allowance that may be justified from an accounting standpoint will fail to meet the situation properly from an investment standpoint.
Depreciation
Depreciation Base: There is support in accounting circles for the theory that the function of the depreciation allowance is to provide for the replacement of the asset at the end of its life rather than merely to write off its cost. If this idea is followed, the current or expected future replacement cost would be the basis for the depreciation charge, and it would vary not only with the value of the identical asset but also with changes in the character of the item that is expected to replace the one worn out.
Two typical misuses of depreciation base accounting by companies: First, marking down of fixed assets, not in the interests of conservatism but with the precisely opposite intent of making a better earnings exhibit. Second, marking up fixed assets yet failing to correspondingly increase their depreciation charged against the income account. In effect, companies were attempting to get the benefit of the higher valuation in their balance sheet without accepting the burden of consequently higher depreciation charges against earnings. Companies should not use one set of values for its balance sheet and another for its income account.
Depreciation Rate: Most companies use the standard depreciation rates. When the analyst knows that a company’s depreciation policy differs from the standard, there is a special reason to check the adequacy of the allowance. Comparison with a single company in the same field may yield significant results. Consider using the ratio of depreciation to property account and ratio of depreciation to sales to compare the two companies or to a single company over many years. E.g., National Biscuit Company, prior to 1922 was constantly adding to the number of its factories but its property account failed to show any appreciable increase. In effect, the capital investment in additional plants were actually being charged against the profits and real profits were much larger than reported.
Depletion (Amortization charges of oil and mining companies)
In addition to depreciation in the ordinary sense – which they usually calculate in the same way as do other companies, Oil and Mining companies must allow for depletion of their ore or oil reserves. Depletion represents the using up of capital assets by turning them into products for sale. As the reserves of these products are exhausted, their value must gradually be written off through charges against earnings.
Mining Companies – Depletion, Development expense
Oil Companies – Depletion, Intangible drilling costs, Unproductive leases: In the oil industry depletion charges are more closely related to the actual cost of doing business than in the case of mining companies. Mining companies ordinarily invest in a single property or group of properties, the cost of which is then written off over a fairly long period of years. The typical oil company normally spends substantial sums each year on new leases and new wells. These additional holdings are needed to make up for the shrinkage of reserves through production. The depletion charge corresponds in some measure, therefore, to a current outlay for the purpose of maintaining reserves and production.
Depletion of oil and gas reserves is based upon the cost of the leases. Unprofitable leases must be written off as some will prove totally valueless and must be charged against the revenue from the productive leases. Intangible drilling costs are written off at one time as equivalent to an operating expense or amortized over the life of the well.
Suggested Approach:
Depreciation on tangible assets – Always at well established rates, applied to cost, or less than cost only if the facts clearly justify the write-down.
Intangible drilling costs – Capitalizing the costs and then writing them off as oil is produced is preferable both for comparative purposes and to supply a fair reflection of current earnings.
Property retirement and abandoned leases – Loss on property retired (in excess of depreciation already accrued) should be charged against the year’s earnings, rather than against surplus as property retirements are likely to be a normal and recurrent factor.
Depletion of oil reserves – Should allow for depletion on the basis at which the oil reserves are valued in the market.
Amortization of leaseholds (Other types of amortization of capital assets)
Leaseholds and Leasehold Improvements: The ordinary lease involves no capital investment by the lessee, who merely undertakes to pay rent in return for the use of property. But if the rental payments are considerably less than the use of the property is worth, and if the arrangement has a considerable period to run, the leasehold may have a substantial value. If a company has paid money for a leasehold, the cost is regarded as a capital investment that should be written off during the life of the lease.
When structures are built on leased property or alterations made or fixtures installed, they are designated as leasehold improvements. Hence, their cost must be written down to nothing during the life of the lease, since they belong to the landlord when the lease expires. The annual charge off for this purpose is called amortization of leasehold improvements.
Amortization of Patents: A patent should be dealt with in exactly the same way as a mining property i.e. its cost to the investor should be written off against earnings during its remaining life.
Amortization of Goodwill: Since goodwill has no duration of life apart from that of the business as a whole, the analyst should adjust the earnings by cancelling the charge.