Depreciation and Amortisation

Depreciation and Amortisation (D&A) are two words that appear on a company's financial statement, but which are not fully understood. D&A are shown for accounting purposes because they are non-cash expenses. In other words, if there is a D&A charge of £5000 on a company's books in 2013, the company would not have paid £5000 in 2013. Both D&A are accounting methods, which allow a company to spread the cost of both tangible and intangible assets over the useful life of the asset rather than as a one-time charge. This is beneficial in that is prevents skewing the first set of results downwards, but it also prevents skewing following sets of results upwards. If the charge was taken up front, then in year 2, the company would be enjoying the benefits of the asset, without incurring a cost. Furthermore, it would lead to a seemingly very volatile profit performance.

- Depreciation is for spreading the cost incurred through the purchase of a tangible asset (e.g. machinery and land)
- Amortisation is for spreading the cost incurred through the purchase of an intangible asset (e.g. licences and patents)

The reason for doing this is to gain a better understanding of the underlying state of the business. If a company invests in a new machine at a cost of £2,000,000, it allows them to spread that cost over time, rather than suffering a large £2m hit on their next results. If the useful life of that machine is 5 years,  the £2,000,000 charge will be spread over 5 years. Seeing as a machine is a tangible asset, this is a depreciation expense and will be charged against profits, thereby reducing the profit numbers.

The fact that D&A are non-cash charges means that many companies include D&A in their EBIT (Earnings before interest and tax) numbers, to form EBITDA (Earnings before interest, tax, depreciation and amortisation). Sometimes this can more accurately reflect the business if there has been a one-off large investment programme at the company, but it also allows comparisons to be made between companies who employ differing D&A methods.

An Example

An example of these charges is shown above, and is for Finsbury Food Group (LSE:FIF), a UK bakery business. This reference relates to the company's cash flows. For the half-year to the end of December, Finsbury made a profit of £1.687m. The company have then adjusted their cash flow upwards to account for D&A (remember that it's a non-cash charge). Notice that in this case, depreciation is high, but there is no amortisation. This makes sense for a food manufacturing business. Bakeries are often capital-intensive in that there are a lot of machines that automate the baking process. Therefore, at some point in the past there would have been large expenses on machines. Those expenses are being spread out, and are reflected in the high depreciation charge. The company has no amortisation. That is because cake/bread manufacturers do not have much in the way of intangible assets, hence there is no cost to spread, in this case.

There are two main types of D&A methods: Straight Line and Reducing Balance. As shown above, straight line depreciation simply takes an expense and spreads it out evenly across time. If a machine is bought for £100,000 and has a useful life of 10 years, then there will be a £10,000 charge shown on the books for 10 years, until the total cost is recovered. On the other hand, reducing balance D&A takes most of the D&A charge at the start of its useful life, and decreasing charges as time passes. Each method has its own merits and the methods used are often presented in a company's annual report.

How can D&A be manipulated?

As with a lot of financial items, D&A can be manipulated. One of the ways is through the use of reducing balance rather than straight line methodology. Whilst reducing balance would initially suppress the company's financial results, financial results in future years would be less adversely impacted compared to the straight line method. When would this be better? If a company is taking on a huge exceptional charge in a particular year, then they may be tempted to use reducing balance in order to have a 'cleaner slate' in future years. D&A methods may also be impacted by the domestic tax regime. If the D&A figures are tax deductible, then there is a temptation to accelerate D&A (through reducing balance), thereby allowing the company to receive tax deductions as soon as possible.

Another way lies in the very definition of useful life. Useful life is itself a very subjective term. There is no set time period that a machine will work for, so there may well be a temptation to extend the useful life of a tangible/intangible asset in order to reduce D&A charges. After all, a £100,000 cost spread out over 10 years is much more material on an annual basis, compared to being spread out over just 2 years.

There is also another subjective decision to be made. If a company believes that a £100,000 will still be worth £20,000 at the end of its useful life, then the D&A charging methods change (assume straight line for this example). As per the table on the right, the D&A charge drops down from £20,000 per year, to £16,000 per year. Therefore, there could be an incentive to overstate the value of the asset at the end of its useful life.

Since D&A reduces profits at both the EBIT and net income level, companies tend to provide investors with 'Adjusted' figures where they strip out D&A from the net income numbers, thus boosting them. In some cases that is acceptable, but in other cases it will simply create an inaccurate portrayal of the company's expenditure patterns. This is one of the core reasons why investors tend to prefer cash flow analysis to income statement analysis - it allows them to see the underlying movements of cash within a business, without the obstacles that depreciation, amortisation, and other items present.