CHAPTER FOUR 4
Depreciation and Amortization for Books and Taxes
THERE IS ONE OVERRIDING principle that a reader should take away from this chapter. Depreciation methods, amortization lives, fixed-asset lives, and salvage values can and probably should differ between financial reporting and taxes. The Internal Revenue Service (IRS) will review that each taxpayer has identified the specific tax accounting requirements for Property, Plant, and Equipment (PP&E) and that the regulations are followed. With regard to PP&E the IRS does not care what a taxpayer does for financial reporting. Only with LIFO (last in, first out) is there a requirement for conformity between book accounting and tax accounting.
Similarly, for financial reporting, how a taxpayer chooses lives, salvage values, and depreciation methods for taxes in no way needs to govern what the company does for its own financial statements. Auditors, reviewing internal controls, will assure themselves that the client is following its own written accounting policies; nothing in generally accepted accounting principles (GAAP) explicitly requires certain specific lives or depreciation methods, much less a single salvage value. As was shown in Chapter 3, current fixed-asset accounting software easily handles differing tax and financial reporting software.
In short, there need be no connection between tax accounting for PP&E and financial reporting of the same assets. As was mentioned in Chapter 2, many companies choose to use both the same lives and same depreciation methods for both books and taxes. But this choice, while frequently made, is not based on any specific accounting or tax requirements.
There is one reason for having the same lives and methods, and that is to preclude the GAAP requirement that deferred taxes be set up for differences between tax accounting and financial accounting. All other things being equal, most companies prefer to minimize deferred taxes if for no other reason than simplifying month-end accounting. The subject of deferred tax accounting is beyond the scope of this book on internal controls. But the slight increase in accounting effort to handle deferred tax accounting is almost always worth the effort to improve overall financial reporting.
Financial managers attempt to maximize after-tax cash flow, and as a generalization utilize the most aggressive, yet acceptable, tax policies which will improve cash flow. This comes at the cost of potentially incurring small increased effort. Keep in mind that deferred tax accounting involves reporting and audit requirements for deferred tax assets and liabilities that are on the balance sheet.
For tax purposes, asset lives have essentially been developed by Congress and the IRS; for taxes IRS Publication 9461 provides exhaustive detail. In addition to prescribed lives the Internal Revenue Code also lays out acceptable depreciation methods. The combination for taxes of specified lives and specified depreciation methods means that if companies follow the advice in this book, and determine depreciation for financial reports separately, there are bound to be accounting differences between books and taxes. In turn, these differences will require calculation and the reporting of deferred tax assets and liabilities. Most companies can handle differences in tax and book reporting and the concomitant deferred tax accounting, but smaller firms may want to ask their financial advisors which way to go.
INTERNAL CONTROL FOR DEPRECIABLE TANGIBLE ASSETS
Note: Land is the only tangible asset that is not depreciated, so this section covers all PP&E including machinery, IT assets, office furniture and fixtures, and buildings, but not land.
Books have been written about internal control and most publicly traded companies issue a report on their internal controls. We are not repeating the broad generalizations that govern the subject, our discussion is limited to factors unique to PP&E.
There are basically two things required in order to meet independent standards of internal control for PP&E:
1. Proper accounting for acquisition, transfer, and disposition of PP&E.
2. Monitoring that the accounting records accurately reflect underlying economics.
DETERMINING USEFUL LIVES WHENEVER NEW ASSETS ARE ACQUIRED
There is a very easy way to tell if you have been assigning appropriate lives to PP&E in your company. Take the existing file and sort it by net book value (original cost less accumulated depreciation). The chances are very high that there will be a substantial number of assets that have been fully depreciated, that show zero net book value, or only salvage value, and the assets are still present and still in use.
By definition, then, a fully depreciated asset still in use had too short a life initially assigned. Of course, circumstances change. It is hard to project out 10, 15, or even 20 years out into the future. It is much easier simply to use the same life required by the IRS for financial reporting. Most companies, in practice, do exactly this.
The rules in GAAP for setting lives and computing depreciation for financial reporting are not prescriptive, unlike the IRS rules. You simply are supposed to assign a life that corresponds to your best estimate of the expected useful (economic) life. If you really expect a salvage value, that is to be set up; salvage values affect depreciation by reducing the total allowable amount charged to expense over the assets’ lives. Many companies do not assign a salvage value, anticipating that by the time an asset is replaced it will have little or no commercial value at that time.
Factors to Be Considered in Setting Lives
Experience has shown that very few assets truly wear out, that is, they have to be taken out of service because they simply cannot be held together. When was the last time you saw a worn-out desk?
Unfortunately, individuals in an accounting department who make decisions concerning the lives of assets are all too familiar with one type of machinery and equipment, the private car that does have a short life due to physical wear and tear. Automobiles, however, are not typical of PP&E in the average company, Hertz and Avis excepted.
As we all know, cars do wear out, and after 150,000 or 200,000 miles most owners decide to buy a new car, they trade in the old auto, because the cost of repairs is getting out of hand. Physical depreciation on productive assets used in the business world does exist, but to a much lesser degree than is usually thought of.
In a production environment preventive maintenance is carried out, while for office furniture and fixtures there is usually little actual wear and tear. Technology assets, computers and related assets, suffer functional obsolescence and thus may have a short economic life. But a 15-year-old computer will probably still perform the functions for which it was designed originally. It is just that developments in new technology rapidly outdate or obsolete older equipment.
Look at buildings, and you see a much different story. The IRS calls for a 39-year life for buildings and many managers then use that life for financial reporting. Taking 2011 as a measure, this would suggest that most buildings constructed prior to 1972 were supposedly at the end of their life. Obviously, many, if not most, structures used for business, retail, wholesale, transportation, and manufacturing last far longer than 39 years. The record, and we do not recommend this as a comparable to be used for financial reporting, is Gothic Cathedrals. There are many churches in Europe still being used for their original purpose, in many cases 600 or more years after construction.
The assets that color individual understanding of asset lives are personal computers and consumer electronics. How many different computers have you had in the last 20 or 25 years? Many individuals probably have upgraded every two or three years, meaning that a two- or three-year life would have been appropriate for financial reporting.
Computers do not wear out. A computer from 15 years ago will still perform all the functions today it was capable of then. It may not be able to handle the “bloated” software now in common usage, but the word processing program from that era will still turn out more than acceptable reports on the computer from that era.
Truth be told, today’s word processing software does very little more than the programs did from that period. Human typing skill has not changed and that is the real limiting factor, not computer speed or software features. Now today’s software for fixed assets probably would not run on a 15-year-old computer, but any of today’s programs on today’s personal computers undoubtedly will be completely functional ten or even 15 years from today.
For valuation specialists who deal in machinery and equipment, much of their professional expertise lies in the determination of remaining useful lives. Keep in mind that the valuation of an asset is itself a function of how long it will continue to be used. Thus, the same asset, if it will become economically or functionally obsolete in five years, will have a lower “value” today than if the same asset could be used for the next 20 years. The value of the asset and the life of the asset are really the two sides of the same coin.
As a generalization, productive assets used in business do not wear out! Very few current capital expenditures are actually to replace existing assets on a one for one basis.
Before getting into the details of setting lives for specific assets or types of assets, let us examine carefully why new assets are acquired. Many, if not most, larger companies have formal capital expenditure approval systems. Companies establish a budget for capital expenditures for the year, then individuals submit requests with justification; a higher level of management then approves or disapproves the request. Companies have a number of different categories into which they slot capital expenditures, and some of the most common are:
• Mandatory. Mandatory capital expenditures (capex) encompass health, safety, and environmental projects which have to be done irrespective of their return on investment (ROI). For this category the usual economic analysis as to future benefits and cash flow is usually omitted. If the Environmental Protection Agency tells you to clean up a site, and you have exhausted your legal defenses, you probably are going to have to spend the money.
• Expansion (existing products). Expansion projects are usually justified on the basis of incremental profits expected from the increased sales of current products that are already doing well. Inasmuch as these are usually based on current production methods, only scaling them up, the types of assets to be acquired are familiar.
• New product. Capex for new products involves more risk and possibly unknown technology. The ultimate success of any new venture is far less secure than the expansion of presently successful activities. For this reason most companies have a higher hurdle rate for this type of proposal.
• Cost reduction. Cost reduction projects usually involve a “make” versus “buy” decision, and if you can do something yourself, and hence not pay a supplier, it is possible for profits to increase. The success of such projects is quite certain because you already know the volumes at which the cost reduction project will run. What may not be as certain is whether or not you can “make” at lower cost than your existing supplier can. Thus there is some risk in terms of making the project work.
• Replacement. Replacement projects are where existing equipment simply is worn out and it is uneconomical to try and fix it. This is the phenomenon we as consumers have with cars and consumer electronics and appliances. After six years it is probably time to trade in your car and in ten years it probably is time to get a new washing machine. These are what we call “one for one” or replacement decisions, and for industry they simply permit the existing business to go along at current levels. But in practice these are fairly rare.
It is our observation over many years in the business world that there is a very low percentage of replacement capex compared to the other four categories. Good maintenance can keep equipment working for many years. This of course is why companies have so many fully depreciated assets physically still in use. The original life fell short of the actual economic utility.
The point of this brief digression is to put into perspective that there are few replacements, relative to all other capex. Unlike individuals who get a new washing machine after ten years, most production managers and plant engineers can get 20, 30, or more years usage out of production equipment.
The conclusion we draw from this analysis is that companies should adopt a new approach to setting financial reporting lives for new capex. In Chapter 8 we take another look at the actual remaining lives for assets already on the books. But for new acquisitions, the time to start is now, from here forward.
CHOOSING ACCOUNTING LIVES
The first place to start is to look at the existing file of fully depreciated assets, those with either zero book value or salvage value only. Take a sample of those items that had too short a life originally assigned, then determine what the real economic life is likely to be. This will involve dialog between the fixed-asset accountant and the appropriate production or IT managers responsible for actually using the asset.
We hate to say it, but the level of knowledge about manufacturing processes for most financial workers ranges from abysmal to none. Accountants really should not be setting expected lives at all—other than for tax purposes. For financial reporting, where the underlying economics should govern, accountants and auditors really are fooling themselves if they believe they know enough to set lives appropriate for actual intended use.
For replacement capex it would be appropriate to use as a life for the newly acquired asset, the actual elapsed time between the acquisition of the original asset and the current date when it is being replaced. If the new asset replaces a similar asset acquired 25 years ago, then assign a 25-year life to the new asset. There have been many studies that suggest simply projecting what has happened in the past is the best estimate of the future. If it rained today, the best forecast for tomorrow is that it will rain then. This does not mean that it will rain continuously from here, but for a one-day forecast it may beat any other forecast. Assigning a 25-year life to the new asset on the basis that the old asset lasted 25 years is as supportable, if not more so, than any other choice.
Taking this approach, in effect lengthening the accounting lives of replacement assets, will have no effect on cash flow, but will have the impact of reporting increased income. Earnings before interest, taxes, depreciation, and amortization (EBITDA), as well as earnings before depreciation, is also not affected by the choice of accounting lives for calculating depreciation.
But having correct economic depreciation will give a better picture of true profitability. Many accountants have been brought up with an expectation that they should always be conservative. In this context, with respect to depreciation expense, conservative is assumed to be that the faster you write off an asset the better. Why it is better, however, has never been made clear, at least to the author.
Understating profitability (the result of overly aggressive depreciation charges) may lead to incorrect product pricing, as well as incorrect financial analysis of the relative profitability of different product lines. This is a point made strongly in cost accounting courses in colleges and universities. Choosing economic reality is usually trumped by the feeling that “it is good to be conservative and even better to be overly conservative.” That bad decisions may arise is not contemplated by the desire for conservatism. But the actual rule for depreciation is very straightforward, as shown in Accounting Standards Codification (ASC) 360-10-35-3:
35-3: “Depreciation expense in financial statements for an asset shall be determined based on the asset’s useful life.”
It does not say to choose a life based on the Internal Revenue Code. It does not say to choose a life that will write the asset off as quickly as possible. It does say exactly what we are recommending. Use the expected useful life.
Without parsing the words too closely “useful life” refers to the period over which the asset will perform its expected function. Thus, what we have to do is anticipate economic lives in order to determine accounting lives.
HOW VALUATION SPECIALISTS DETERMINE ECONOMIC LIVES
In valuing an existing factory full of equipment, the appraiser attempts to determine for each significant asset how much of the real useful life has been used up or expired and how much remains. The thought process looks at the economics of the operation, taking into consideration current maintenance policies, and how well they are practiced. Machinery and equipment appraisers typically disregard accounting lives and book balances (original cost less accumulated financial depreciation).
This actually is common sense, once one considers this. If you maintain your car, changing the oil every 5,000 miles, and so forth, the car will last a lot longer than if you simply fill it up with gas and drive it until it falls apart. The same holds true in a manufacturing environment. Preventive maintenance is the “gold standard”; machinery and equipment appraisers are trained to evaluate what a company is doing, irrespective of what a written policy says is supposed to happen.
Take airplanes, where preventive maintenance is scrupulously followed, occasional complaints by the Federal Aviation Administration (FAA) notwithstanding. The U.S. Air Force is still flying bombers built in the 1950s and actually relying on them for much of the United States’ offensive capability. Some observers have pointed out that over the 50-year period virtually 100% of the original aircraft has been physically replaced, so perhaps it is semantics to say that the original bomber is now 50 years old. But if it is not the original aircraft, thoroughly maintained, then what is it?
The point here is that with good maintenance assets can, and do, last a lot longer than is usually thought. This has implications for the lives assigned to new asset acquisitions. What we recommend is simple and straightforward: Instead of an accountant setting the economic lives, have the owner or user of the asset determine the life. That is, the individual or department, which will bear the depreciation charge. Keep in mind that depreciation expense, no matter how often people call it a “noncash charge” does represent actual expense associated with the original purchase. The cost of an asset has to be reflected in the selling price of the assets made from that asset.
Perhaps the simplest example would be an excavating contractor who uses a Caterpillar bulldozer. Most contractors determine a “cost per hour of operation” and then charge that to jobs and use that charge in their cost estimating and pricing. Assets have a cost, and the per-unit cost is a function of the expected future use. Underestimating that use, or useful life, throws off all cost and profit analyses.
Therefore, go to the most knowledgeable people in the company, the users of the assets. This means that for computers and related gear, go to the head of IT. For buildings, ask the real estate manager. For machinery and equipment the experts are in production and maintenance, not sitting in the accounting department. In fact the only asset that accountants should determine the life of is office furniture and HP calculators! And the latter should have been charged to expense, not capitalized.
DETERMINING LIVES FOR INTANGIBLE ASSETS
For tax purposes, the answer is crystal clear. Internal Revenue Code §197 specifies, without any distinctions, that all intangible assets, including goodwill, are to be amortized over 15 years. There is no choice: 15 years, no more and no less. This was put into the Code at the behest of the IRS, and agreed to by industry, to eliminate the interminable fights over lives that took place prior to §197’s enactment.
The IRS had not allowed goodwill to be amortized for tax purposes, but did allow amortization for intangible assets where the taxpayer could demonstrate a definitive life and a definitive value. Thus, there was pressure by taxpayers to try and carve out of goodwill any number of identifiable intangibles and valuation firms were hired to value these and determine a specific life.
The IRS, seeing tax revenues drain away, almost invariably challenged these intangibles, such as customer relationships or assembled workforce, and alleged they were simply components of goodwill and hence not amortizable. The disputes ended up in court, consuming real resources in what was essentially a zero-sum game between taxpayers and the IRS. Finally, both sides threw in the towel and agreed that 15 years for everything, including goodwill, was a reasonable compromise.
This 15-year rule does have some unexpected consequences, however. A five-year noncompete contract obviously has no value after five years. But under today’s tax rules such an asset still must be amortized over 15 years. Similarly, while goodwill is never amortized for financial reporting under GAAP, it is given a 15-year life for tax purposes.
Where lives for intangible assets do become critical is in financial reporting. Goodwill is never amortized, following issuance of Statement of Financial Accounting Standards (SFAS) 157 Fair Value, now ASC 820. In exchange for getting rid of “Pooling of Interests” accounting the Financial Accounting Standards Board (FASB) permitted goodwill to be tested periodically for impairment. Absent an impairment, however, goodwill is not amortized; further it is treated as having what is called an “indefinite” life. Important to this discussion is that indefinite does not mean “infinite,” it merely means that we do not know today when the useful life may end. This distinction becomes important and is discussed ahead.
Nonamortization of goodwill, following a business combination, is highly prized by CFOs and controllers, who thereby do not have a charge reducing earnings and hence earnings per share (EPS). This initial determination of the amount of goodwill occurs in an allocation of purchase price. Since most other intangible assets with a specific life do have to be amortized, and such amortization reduces EPS, financial officers usually want as much of the total purchase price allocated to goodwill and as little as possible to amortizable intangibles.
Now we get to the critical element of this section. What is the appropriate life to be assigned to specific intangible assets? The answer “it depends” is not particularly helpful. The rule that is supposed to be followed is to assign a life for reporting purposes that is commensurate with the useful life or expected utility of the asset, just as with fixed assets. This certainly leads immediately to the next question, of how do you determine the useful life of an asset? We mentioned above a five-year covenant not to compete, and the useful life would in most cases be determined as five years. Similarly, a patent with seven years remaining before expiration would ordinarily be assigned a seven-year life.
These examples beg the question for assets that do not have clearly defined or delineated terms until expiration. The issue here is that the assigned life at times directly affects the value. As a simple example, if in an allocation of purchase price you assume a five-year life for royalty income, say on a software system the target company licenses to customers, then the value of the license might be $1 million. But if you assume the revenue stream could last eight years, the value might be $1.2 million. The length of an income stream directly corresponds (on a discounted basis) to the anticipated life.
In terms of internal controls, the main subject of this book, it is critical that the estimates of lives of intangibles be assessed as accurately as possible. Overassessment, putting too long a life and hence too high a value, is likely to result in future impairment charges, which no financial officer (not to mention top management and security analysts or shareholders) likes to see. It is true that a longer life does reduce the charge to expense in the early years, at the expense of having the amortization charge go on for a long period of time.
However, deliberately underestimating the life of the intangible, and hence underestimating the value of the asset risks putting too much of the purchase price into goodwill. While not directly impacting short-run EPS, an overstatement of goodwill may cause an impairment charge for goodwill. Inasmuch as many observers think that in 60 to 70% of M&A (mergers and acquisitions) transactions the buyer has overpaid, the risk of a goodwill impairment charge should not be dismissed out of hand. As was seen in the 2008-2009 downturn, with stock prices depressed, many companies were forced to take unanticipated goodwill impairment charges. We have seen a number of instances where the goodwill impairment charge was higher than it need to have been because of prior errors in correctly estimating the lives (and hence the amount) of amortizable intangibles.
Also, at least a word of warning. Putting more of a purchase price into goodwill, to reduce depreciation and amortization charges, risks very close scrutiny by the Securities and Exchange Commission (SEC) and public accountants. The SEC is particularly vigilant in this area, and does not hesitate to ask companies why such a high percentage of the purchase price was assigned to goodwill. In effect, they are asking why did you buy that company, what did you think you were getting. Was it products? Research? Customers? The questions can become pretty pointed.
One suggestion for purchase price allocations should be kept in mind. In many instances companies are permitted to assign an indefinite life to trade names. Remember that when an indefinite life is assigned, there is no annual depreciation charge. Consequently, many companies believe that the trade names they acquired in an M&A transaction truly have an indefinite life-and no amortization is required. Unfortunately, as a number of our clients have found out, too late, buyers often stop using acquired trade names, or minimize the marketing resources devoted to the trade name.
Common sense suggests that when marketing resources are reduced, the value of any trade name, or product line, is similarly diminished. The impairment test for indefinite life assets is materially different, and far more stringent, than that for amortizable assets. One has to determine the current fair value of a trade name each year if no life has been assigned. Then if sales of the product/product line go down there is almost certainly going to be a required impairment charge. However, if a definite life had been assigned, say 30 years, and sales drop off because of reduced marketing expenditures (or any other reason for that matter) the impairment test is quite easy to pass. Right or wrong, the FASB has mandated that the impairment test for amortizable assets, both tangible and intangible be based on undiscounted future cash flows; this test is usually met so our clients have experienced few impairment charges for trade names that are being amortized.
CHANGING LIVES AND DEPRECIATION FOR EXISTING ASSETS
Often it becomes obvious that an asset will last either a shorter, or longer, time than was originally contemplated. Here is what GAAP says:
35-22 When a long-lived asset (asset group) is tested for recoverability, it also may be necessary to review depreciation estimates and methods as required by Topic 250 or the amortization period as required by Topic 350. Paragraphs 250-10-45-17 through 45-20 and 250-10-50-4 address the accounting for changes in estimates, including changes in the method of depreciation
50-4 The effect on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), and any related per-share amounts of the current period shall be disclosed for a change in estimate that affects several future periods, such as a change in service lives of depreciable assets. Disclosure of those effects is not necessary for estimates made each period in the ordinary course of accounting for items such as uncollectible accounts or inventory obsolescence; however, disclosure is required if the effect of a change in the estimate is material. When an entity effects a change in estimate by changing an accounting principle, the disclosures required by paragraphs 250-10-50-1 through 50-3 also are required. If a change in estimate does not have a material effect in the period of change but is reasonably certain to have a material effect in later periods, a description of that change in estimate shall be disclosed whenever the financial statements of the period of change are presented
Inasmuch as we believe that most companies are using lives that are too short, it might pay to study the impact of lengthening lives. As noted previously, of course, it would be necessary to have footnote disclosure of the impact of the change. Making this change on a wholesale basis is probably not for the faint of heart, but there will be very sound support for the move, merely by looking at the fully depreciated assets, and assets that are within a year or two of becoming fully depreciated.
If the assets are going to be used for more years than was originally set forth, it would appear to be better internal control, working with your auditing firm and perhaps a valuation firm, to accomplish the task and explain, so that security analysts do not draw the wrong opinion.
LEASING AS A WAY TO UTILIZE DEPRECIATION
Companies with net operating losses (NOL) can often not take advantage of the deduction for the current allowable depreciation expense. If you have an NOL that will likely carry forward for several years, there is no point in increasing tax losses by throwing in depreciation. However, the IRS does not allow you to “skip” depreciation for a year or two, whether you can use it or not. Depreciation for taxes must be taken, irrespective of the impact on profit or loss.
There are, however, many companies that can use depreciation because they are in a favorable profit, and hence tax-paying, condition. Nature abhors a vacuum, and unutilized tax depreciation in fact has value to such taxpayers. This is the logic behind much equipment leasing.
It is beyond the scope of this book to go into leasing, inasmuch as many long books on leasing have already been published. But if a company has NOL a good way of minimizing the impact would be to examine the economics of equipment leasing. If the lessor can use the depreciation that you cannot use, this can often be translated into an effective lower interest cost.
SUMMARY
A key point of this chapter, and for the book as a whole, is that depreciation expense for any asset, or group of assets, should be determined based on the expected economic life. Simply using the same life for financial reporting as recommended by the IRS will cause assets to be depreciated too quickly. This, in turn, has an impact on reported net income, albeit not to EBITDA.
Companies can develop reasonable estimates for lives to be assigned to newly acquired assets by reviewing actual usage of existing assets. Assets still in use, but fully written off, represent past errors in the estimated life, an error which need not be repeated.
Tax lives and depreciation methods have been developed to meet social and economic needs of the economy as a whole; they were not developed based on actual or expected economic utility. Financial reporting companies must cut the tie between tax and financial depreciation.
NOTE
1 IRS Publication 946 can be referenced at www.IRS.gov.
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