Any depreciation schedule is inevitably simplistic, and depreciation requires the accountant to make judgements – about the useful life of the asset and about its ultimate value. But this is the whole point about depreciation – accounting depreciation is an efficient system that avoids the prohibitive costs of revaluing all assets annually to figure out how much of their value has been consumed in the year, that is, their economic depreciation.
Nonetheless people latch on to the subjectivity, and on to the fact that depreciation relates to expenditure that may have taken place a long time in the past. All of this tempts them to conclude that depreciation is not a real cost at all and is ‘just bookkeeping’. As the note reports, the idea of depreciation has been around for a long time and, throughout history, people have found it easy to ignore depreciation when it suited them, which was usually when they were unprofitable. At least in the old days people did not try to justify ignoring depreciation but, more recently, ignoring depreciation has been sanctified as part of the cult of EBITDA.
Earnings before interest, tax, depreciation and amortisation (EBITDA) is EBIT with depreciation and amortisation added back. Its popularity as a measure grew in the late nineties when, coincidentally, there were many loss-making technology businesses on the market at sky high valuations. Since EBITDA was more likely to be positive than EBIT, it provided a useful basis for valuation multiples.
Used with care, EBITDA can be a useful way of isolating a certain subset of costs when comparing a group of similar companies. But too often it tends to be justified with the argument that, by omitting depreciation and amortisation, EBITDA represents a better measure of profit, one that better approximates cash flow. This is nonsense. Depreciation is a very real cost. It is the cost of consuming productive capacity. For some capital-intensive companies, depreciation is the largest cost they have. If we omit depreciation, we are not measuring income.
On the whole, it makes sense to trust companies to choose sensible depreciation schedules, and to rely on GAAP and on the auditor. But, as always, we need to be vigilant. If a company’s depreciation seems inappropriately liberal or conservative, the solution is to recalculate it on a more appropriate basis.
There is a view on the street as follows: ‘Cash flow measures are reliable because, unlike profit measures, they are not vulnerable to accounting. After all, taking the raw transactional data and pushing it around between periods using judgments about accruals is what accountants do. The cash flow statement simply undoes these accruals.’
A popular version of this view then says, ‘Depreciation and amortisation are pretty soft accounting numbers, so let’s add them and other long-term accruals back to EBIT to give us EBITDA, a hard number that will proxy cash flow.’
Unfortunately, the general view that cash flow is robust to accounting choices is, at best, only partly true and the specific view about EBITDA is wrong. Accrual accounting gets reversed at different points through the cash flow statement so, in general, cash flow statements get more robust to the effects of accounting policy choice the further down the page you go. For example, revenue anticipation is reversed in working capital investment, cost capitalisation is reversed in capex. EBITDA is at the top of the cash flow statement and it is the cash flow measure that is most vulnerable to accounting. Analysts developed an increasing enthusiasm for EBITDA in the late nineties, so flattering EBITDA became an easy option for a company in financial difficulties such as WorldCom.