Security Analysis Series: Chapter 34 Summary

“The Relation of Depreciation and Similar Charges to Earning Power”

Chapter Summary

  • The basic idea behind depreciation is that the earning power of fixed assets reduce over time, thus we write-off that cost by amortizing and charging against earnings. (pg 453).
  • Graham takes three issues with the above concept (pg 453):
    • 1. Accounting rules vary in their use of a base for depreciation.
    • 2. Companies can find ways to warp reported depreciation accounting rules to their gain.
    • 3. There can exist times when an “allowance that may be justified from an accounting standpoint” will not satisfy that same allowance from an investor’s standpoint.
  • Due to the market’s great importance placed on earnings, companies often willingly mark down assets for the purpose of reducing depreciation charges. (pg 455).
    • The inverse can also happen, where mark-ups occur but cost is still maintained as the depreciation base.
      • “…no company should use one set of values for its balance sheet and another for its income account.” (pg 456).
  • Calculating the % of depreciation charged to the appropriate fixed asset account, or total fixed assets, allows for a handy comparison year-over-year, or company to company. (pg 460).
  • On occasion, companies can actually expense capital expenditures, rather than capitalize them. This leads to lower depreciation charges, and even lower reported earnings. Graham provides an example where a change in accounting policy served to double earnings, largely due to the company starting to capitalize, rather than expense capital expenditures. (pg 463).
  • Mining and oil companies must charge expenses for the depletion of their reserves. An independent calculation of depletion expense “based on the amount that he has paid” is necessary. It is necessarily difficult, and one must carefully study and understand the estimated life of the resources in his calculations.
    • Oil is slightly different from mining, in that new wells “may yield as high as 80% of their total output during the first year”, which brings drastic variation in earnings, and the subsequent writing-off of the entire reserve in almost a single year. Thus, if the property is not written off rapidly via depletion, earnings and property will both be dramatically overstated. (pg 465).
    • As a solution to the aforementioned problems, Graham recommends that mining and oil depreciation on tangible assets be compared to relatively similar resources, while intangible drilling costs ought to be capitalized, as opposed to expensed in a single year (though this is the less conservative approach, it supplies the most accurate picture of earnings). Adjustments to accounting are necessary to make comparisons in situations where they differ. (pg 468).
      • For depletion of integrated oil companies, Graham suggests accepting their figure, while sole oil producers are apt to be comparable against competitors. (pg 469).
    • Property retirement losses and costs ought to be charged against earnings, rather than surplus; this is because property retirement is to be expected and recurrent in these businesses. (pg 468).
  • Leasehold improvements may have substantial capital value in certain situations where a lease is for a considerable period of time; thus capitalization and amortization is appropriate in some circumstances (such as grocery store chains). (pg 470).
  • Patents are capitalized based on book value, which typically has no relevance to the true value of the asset. But in theory, they should be capitalized and amortized across the life of the patent, even if accounting standards currently use a fairly arbitrary base. (pg 471).

Chapter Thoughts and Analysis

  • The most valuable piece of advice in this chapter, at least to me, is the concept of comparing depreciation charges as a % of fixed assets across companies and years, which will allow the establishing of industry standards. These standards can then be used to determine what companies apply their rates conservatively, how it affects their earnings, and other consequences of their policy choices.
    • Obviously a case by case analysis is necessary. It is quite logical that more poor quality fixed assets ought to be charged against earnings faster than the high quality assets of another company. Or, in the mining industry for example, depletion charges will vary from project to project, naturally. Perhaps it is the case that in order for one to determine if depletion or depreciation charges are appropriate, advanced knowledge of the industry is necessary. This lends itself to Buffett’s idea of investing in what you know.
  • It is highly important to understand that Graham’s advocacy of capitalizing drilling costs in the oil sector does not apply to all drilling costs, in either the oil or mining industry. The idea of capitalizing exploration drilling costs in the mining industry is ludicrous, as the drilling cost has no bearing on the fundamental value of the body, other than for the purpose of revealing enhanced knowledge of the resource. But it is the knowledge provided by the costs, not the costs themselves, that determine the value.
  • Graham’s point that retirement costs in the oil and mining industries are a standard part of a business, and thus ought to be charged to earnings, is excellent. Today’s accounting standards cover these costs through “Asset Retirement Obligation” liability accounts, however. But perhaps the existence of unreported future obligations in retirement also ought to be considered in further research.
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