Chapter 34: The Relation of Depreciation and Similar Charges to Earning

Power

Summary

A critical analysis of an income account must pay particular attention to the amounts deducted
for depreciation and kindred charges.

Detailed Summary

- Accounting theory governing depreciation charges:

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.

- The analyst should ask three questions with respect to the depreciation feature of an income
account:

1. Have the amortization charges been deducted from the earnings as here reported.
2. Are the rates employed reasonable, as judged by standard accounting practice?
3. Does the cost or lease to which these rates are applied reflect reasonably well the fair
value of these assets to the investor?

- Another misleading practice: A fairly careful investor will know enough to reject an earnings
statement in which it is announced that no allowance for depreciation has been made. But where
the figures are given "after depreciation" he is not likely to make further inquiry on this point, so
that an understatement of these charges may do more real damage than their complete and
admitted exclusion.

- Double accounting policies on depreciation: This is an issue of overshadowing importance in

the accounting practices of public utility systems.
American Water Work & Electric Company then year convertible 5% bonds in Feb. 1934 are
cited as an example, which disclosed that the company had regularly been employing two
different bases for calculating property amortization charges.

1. For income tax purposes

2. At a much lower rate, in its reports to security holders

If the company's own figures are used then its income tax rate would need to be adjusted.

- Suggested Approach:

Leasehold & Leasehold improvements: 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.
Additionally, if any structural improvements or fixtures installed, their cost must be written
down to nothing during the life of the lease, since they belong to the landlord when the lease
expires.

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.

Quotes

"The safety of senior securities or the attractiveness of a common stock should not be considered
as established unless the question of the adequacy of the amortization charges has been raised
and answered in the affirmative." pg. 404

" There is no convincing excuse for failure to state the amount of the depreciation charge, if no
satisfactory indications on this point are available, the conservatively minded should resolve any
doubt against the company."
Questions

1. Is the American Water Work & Electric Company example still relevant? Do some public
utility companies still calculate depreciation charges in this manner?