On Depreciation Reserves & Non-GAAP Earnings

Capital Maintenance - Why is a Depreciation Expense Required?

Economic calculation requires the entrepreneur to calculate his profits accurately so as to ensure he does not appropriate any amounts from earnings as dividends, in excess of the amount needed to maintain the income and scale of the enterprise. A key component in the profit & loss statement is the depreciation expense debited in respect of property, plant & equipment employed in production. This expense is not an actual cash outflow; rather it is an estimate of the reserves needed to finance future capital outlays.

Maintenance of capital is one of the fundamental principles in many accounting standards frameworks. The sustenance of any enterprise relies on its capacity to produce earnings that are consistent (roughly) year-in and year-out. If the entrepreneur deceives himself and shows excess earnings, he might start drawing sums as dividends out of capital, and eventually putting his enterprise at danger. For when capital outlays would be needed in the future - not to expand but to maintain earnings or productive capacity - he will realise he is at a want of funds for having drawn out excessive dividends in the past. The depreciation reserve set aside from current profits addresses this precise risk.

Note that we are only interested in setting aside adequate earnings for capital outlays that maintain the existing level of earnings or productive capacity of the enterprise. Expansions may be financed from earnings retained over and above the depreciation reserve, as per the discretion of the entrepreneur and depending on his capital structure preference.

This is particularly the case for manufacturing entities possessing all sorts of technical and complex machinery. These machines tend to last for 5, 10 or even 20 years, and require replacement for reasons of obsolescence, general use, wear & tear, etc.; meaning that a fresh outlay is needed periodically to replace this equipment and continue to produce the same quantity of output as before. This notion of capital maintenance is purely 'physical', but it goes beyond that.

Take the case of a pharmaceutical company that needs to spend a continual minimum amount on development & discovery of new drugs to remain competitive in the market. Here, there are no physical assets to be replaced, rather some essential expenditures on intangible assets required to compete in the market and maintain a general level of earnings (In fact, a growth in earnings is also often achieved with such development activities). We are alluding to an extended, economic concept of capital maintenance where the enterprise has to spend sums to maintain its relative position in the market. Although, in practice, accountancy doesn't have the tools to compute the adequate reserves for such kind of maintenance - this is more of a mental & judgmental calculation of the entrepreneur.

Menace of Alternative Non-GAAP Measures

Given the backdrop, it is a universal accounting practice to make an allowance out of current profits for a depreciation expense. There are alternative Non-GAAP measures, however, that do not follow this practice and often add back depreciation in arriving at a more 'appropriate' performance measure. Such a practice is beset with numerous conflicts of interest in managing stakeholder perceptions - on the side of the company's finance department publishing these measures, and on the of side the market analysts publishing reports about the company's securities.

Deciding on which items to add back or deduct as 'abnormal' or 'non-core' can lead to exclusions of  true economic costs of the entity. Hence, GAAP measures are always recommended when analysing entity performance; any adjustment thereto must have a robust economic rationale. 

Specifically, on adjusting depreciation, the most asinine alternative measure is 'EBITDA' - Earnings Before Interest Taxes Depreciation & Amortisation. If the reader refers to the various criticisms levelled against Non-GAAP earnings measures by Warren Buffett and Charlie Munger, at their Annual Shareholder Meetings of Berkshire Hathaway, he will not need further convicing. Charlie Munger even went on to call EBITDA earnings - 'Bullshit earnings'. Their contention with EBITDA is primarily a contention with the view that holds depreciation as an inconsequential book adjustment, rather than a genuine economic cost.

As detailed before, this is just now true. Let me restate like a broken record, the importance of the capital maintenance mandate of the enterprise, which clearly underlines the fact that depreciation serves as a cost that needs to be borne to sustain the current level of earnings. Again, we are not concerned with setting out of profits to finance business expansions - these are at the choice of the entrepreneur, as per his capital structure preferences. He may finance expansions out of debt, it would not compromise the capital maintenance mandate of the firm.

A more palatable alternative to EBITDA is Free Cash Flow to Equity (FCFE) wherein, depreciation is added back and investing cash outflows (mainly purchases of new plant & equipment) are deducted from book profits. FCFE does away with the accounting uncertainty involved in estimates of depreciation, and it measures more directly the actual cash flow earning trends of the business after considering the impact of expected capital expenditures. FCFE considers capital expenditure as a true economic cost to the business, as was intended with the accounting measure of depreciation. 

In Discounted Cash Flow (DCF) computations, all net cashflows, including the capital purchases are undoubtedly relevant to the investor's valuation of the business. We have less qualms with using FCFE, then. However, even in using FCFE measures, the analyst has not discarded an element of estimation or judgment. Ultimately, such measures involve predicting future actions. Often, the anticipated capital expenditures in future periods need not always align with actual business plans. Hence, if FCFE is regarded as somehow more certain than GAAP earnings, I would be very cautious in taking such a bold view. When looking at past records to measure FCFE, there is also the added challenge of separating capital outlays that produce increment in earnings and those that maintain the current level of earnings. So, even when historical performance is being adjudged, FCFE certainly requires some estimation or judgment in that regard.

Closing Out

In conclusion I will only say one thing to stand in defence of the accountancy profession. Given the limitations with alternative earnings measures, why not simply rely on earnings figures that are - (i) Audited, (ii) Standardised and (iii) GAAP - compliant? Certainly stands as the lesser evil.

Siddharth Kulkarni
Accountancy professional | CA Student