04-20-2014, 10:50 PM
(This post was last modified: 04-21-2014, 12:10 AM by Dividend Watcher.)
Part of the problem is the difference between the real world and the accounting world and it can get quite complicated. I'll try to make a brief stab at it.
First off, the goal of accounting is to accurately show the financial results of an entity. Further, it tries to match the inputs (revenues) and outputs (expenses) with the periods they actually affect the business. This way you can compare between other companies and standards and well as different periods of time for the same company's financial reports. The procedures for recording this has been accepted as the common method of reporting this stuff so everyone is talking the same language. Hence the Generally Accepted Accounting Principles (GAAP).
Hopefully I won't confuse this too much so soon but there are two basic equations that govern accounting:
The first equation, affectionately called the "Accounting Equation", is a snapshot in time of what a company owns and what it owes. Equity is what's left over after all the liabilities are paid and commonly called the Book Value.
The second equation, the P&L for short, measures the profitability over a specified period of time; e.g., quarter, year, etc. and generally ignores what they own and owe. It only measures the money into and out of the business for the time period you're looking at.
You'll see these two reports for any company you're investigating. Both are important.
Profits can be used to pay off debt (liabilities) or put in the bank (assets), keeping the first equation in balance. That's why I like to use the concept of profit=equity to relate the two equations.
Now, back to your question.
In actuality, the truck is not deducted from earnings. All you are essentially doing is trading one asset, the money in the bank, for another asset, the truck (see equation 1). You haven't expensed anything.
That's great on day one. The truck is worth what you paid for it. Over time, however, the truck becomes less valuable because of wear & tear. It also is something that produces income for the company over a number of years. So, ten years from now, when they sell it, FedEx no longer can trade the asset for the original value in cash. You have to account for that decrease in value somehow. That is the depreciation expense which IS deducted from the revenues over time to reflect this decrease in value.
Remember I said you want to match the income and expenses when they actually occur? The depreciation time and values deducted are determined depending on the type of asset it is. Obviously, a truck will not last as long as a building so it will be depreciated over a shorter time frame.
You're forgetting the truck is an income-producing asset. So, in reality, the decrease in the value of the truck (book value decrease) should decrease at a slower rate than the income it produces over time (book value increase). If not, why would the company even buy it? This profit (=equity or book value) should be greater than the decrease in value of the truck which should make the company more valuable.
Nope. Never deducted from earnings in the first place. Depreciation records the decrease in value commensurate with the economic benefit derived from its use in the approprate accounting periods.
It does and is handled the same way.
Exactly as I described. It's the method of showing expenses for long-lived assets over a period of time which, theoretically, is the useful life of the asset.
Since it is a non-cash expense once it's been paid for, you can add the depreciation back to net earnings to get the cash flow and see what the company has to work with. What Warren is probably talking about is ignoring depreciation and taxes to see how well a company is doing. If FedEx needs 10 trucks to do all their deliveries but the slick truck salesman talks them into buying 100 trucks, the depreciation on those 90 idle trucks is being pissed away which will affect their ability to make a profit. If they only buy the 10 trucks, and they are doing the work of earning money for the company, then it is an expense but is being compensated for by the income. The same can be said for buying a business. If you overpay for it, those expenses have to be depreciated and can really hurt a company's performance.
Hope that provides some understanding. It's a complicated concept but essential when reading financial statements. When I taught small business bookkeeping for the Small Business Development Center, I had a 4 page primer that just covered capital transactions. You'd be surprised how many small business owners don't understand these concepts to their own detriment.
First off, the goal of accounting is to accurately show the financial results of an entity. Further, it tries to match the inputs (revenues) and outputs (expenses) with the periods they actually affect the business. This way you can compare between other companies and standards and well as different periods of time for the same company's financial reports. The procedures for recording this has been accepted as the common method of reporting this stuff so everyone is talking the same language. Hence the Generally Accepted Accounting Principles (GAAP).
Hopefully I won't confuse this too much so soon but there are two basic equations that govern accounting:
- Assets = Liabilities + Equity (Balance Sheet)
- Profit = Income - Expenses (Income Statement or Profit & Loss Statement)
The first equation, affectionately called the "Accounting Equation", is a snapshot in time of what a company owns and what it owes. Equity is what's left over after all the liabilities are paid and commonly called the Book Value.
The second equation, the P&L for short, measures the profitability over a specified period of time; e.g., quarter, year, etc. and generally ignores what they own and owe. It only measures the money into and out of the business for the time period you're looking at.
You'll see these two reports for any company you're investigating. Both are important.
Profits can be used to pay off debt (liabilities) or put in the bank (assets), keeping the first equation in balance. That's why I like to use the concept of profit=equity to relate the two equations.
Now, back to your question.
(04-20-2014, 08:08 PM)earthtodan Wrote: For example, let's say UPS buys a new truck. For the sake of simplicity let's say they pay for the whole thing up front. The cost of the truck gets subtracted from the company's earnings that quarter, because it was money out of pocket. The book value of the company does not change, except by the difference between the cash spent on the truck and its immediately depreciated value.
In actuality, the truck is not deducted from earnings. All you are essentially doing is trading one asset, the money in the bank, for another asset, the truck (see equation 1). You haven't expensed anything.
That's great on day one. The truck is worth what you paid for it. Over time, however, the truck becomes less valuable because of wear & tear. It also is something that produces income for the company over a number of years. So, ten years from now, when they sell it, FedEx no longer can trade the asset for the original value in cash. You have to account for that decrease in value somehow. That is the depreciation expense which IS deducted from the revenues over time to reflect this decrease in value.
Remember I said you want to match the income and expenses when they actually occur? The depreciation time and values deducted are determined depending on the type of asset it is. Obviously, a truck will not last as long as a building so it will be depreciated over a shorter time frame.
(04-20-2014, 08:08 PM)earthtodan Wrote: In subsequent quarters, the value of the truck declines, and the book value of the company along with it, but that doesn't cost UPS any money because it's already been paid for. All maintenance counts as OpEx. When the truck outlives its economic life and they sell it, they will exchange its depreciated value for cash, and the depreciation of the asset will have already been reflected in the book value of the company. In my mind, that should be the end of story.
You're forgetting the truck is an income-producing asset. So, in reality, the decrease in the value of the truck (book value decrease) should decrease at a slower rate than the income it produces over time (book value increase). If not, why would the company even buy it? This profit (=equity or book value) should be greater than the decrease in value of the truck which should make the company more valuable.
(04-20-2014, 08:08 PM)earthtodan Wrote: However in recording depreciation against EPS every quarter, it seems like companies are recording the cost of an asset twice.
Nope. Never deducted from earnings in the first place. Depreciation records the decrease in value commensurate with the economic benefit derived from its use in the approprate accounting periods.
(04-20-2014, 08:08 PM)earthtodan Wrote: The same should go for pipelines, drill rigs, railroad tracks, airplanes, office chairs, etc.
It does and is handled the same way.
(04-20-2014, 08:08 PM)earthtodan Wrote: I was secure in this conclusion until I read the 2013 Berkshire Hathaway letter to shareholders. On page 14, Warren Buffet states:
Quote:Every dime of depreciation expense we report, however, is a real cost. And that’s true at almost all other companies as well. When Wall Streeters tout EBITDA as a valuation guide, button your wallet.
Warren Buffet isn't one to defend GAAP accounting in order to maintain the status quo; in fact, in the previous pages of this letter he makes clear his disdain for GAAP rules he does not agree with. Therefore it seems that he genuinely believes that depreciation costs a company money. So I ask the forum: How can that be?
Exactly as I described. It's the method of showing expenses for long-lived assets over a period of time which, theoretically, is the useful life of the asset.
Since it is a non-cash expense once it's been paid for, you can add the depreciation back to net earnings to get the cash flow and see what the company has to work with. What Warren is probably talking about is ignoring depreciation and taxes to see how well a company is doing. If FedEx needs 10 trucks to do all their deliveries but the slick truck salesman talks them into buying 100 trucks, the depreciation on those 90 idle trucks is being pissed away which will affect their ability to make a profit. If they only buy the 10 trucks, and they are doing the work of earning money for the company, then it is an expense but is being compensated for by the income. The same can be said for buying a business. If you overpay for it, those expenses have to be depreciated and can really hurt a company's performance.
Hope that provides some understanding. It's a complicated concept but essential when reading financial statements. When I taught small business bookkeeping for the Small Business Development Center, I had a 4 page primer that just covered capital transactions. You'd be surprised how many small business owners don't understand these concepts to their own detriment.
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“While the dividend itself is merely a rearrangement of equity, over time it's more like owning an apple tree. The tree grows the apples back again and again and again, and the theoretical value of the tree doesn't change just because of when the apples are about to fall.” - earthtodan
“While the dividend itself is merely a rearrangement of equity, over time it's more like owning an apple tree. The tree grows the apples back again and again and again, and the theoretical value of the tree doesn't change just because of when the apples are about to fall.” - earthtodan