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Understanding Asset Valuation With Depreciation and Amortization: A Q&A with Monty Magleby

Today we have Monty Magleby here to give us insights on depreciation and amortization. We’ve come up with some great questions to ask him and got some advice from our senior financial consultant. Thanks for joining us today Monty!


Question:

We know that depreciation is the word we use for tangible assets while amortization is the word used for intangible assets. Can you provide insights into why there's a distinction in terminology and accounting treatment between these two types of assets?


Yes, the differentiation in terminology and accounting treatment is rooted in the fundamental characteristics of tangible and intangible assets. Depreciation is applied to tangible assets, which are physical and can be touched or seen, including equipment and vehicles. The rationale behind using the term "depreciation" for tangible assets lies in the natural wear and tear or physical deterioration these assets may experience over time. The accounting treatment involves spreading out the costs of these tangible assets over their estimated “useful lives” to align with one of the funding principles of accounting which is the “matching principle,” which always tries to match costs with benefits.


On the other hand, amortization is employed for intangible assets, which lack physical substance but still hold intrinsic value, such as software, patents, and copyrights. The term "amortization" is used because it reflects the process of gradually allocating the cost of intangible assets over their expected useful lives. Unlike tangible assets, intangible assets may not physically deteriorate, but they still tend to lose value over time. This could happen because technology seems to advance or there could be legal limitations. For example, software may become outdated or a patent may decrease in value because of new innovations in that particular technology.


One other important difference between depreciation and amortization is that amortization usually employs the straight-line method of spreading the asset’s costs over its useful life, whereas many depreciation methods can be used including accelerated depreciation that may offer tax breaks and other advantages in the short term to the company.


The fundamental reason that companies are required to capitalize these costs over time goes back that the “matching principle” of accounting. If companies were to fully expense certain large costs like buildings or equipment all in the year they were acquired, that would greatly reduce their profit for that year, and then perhaps artificially boost their profit the next year since none of those expenses would be shown. That would make their profit kind of 'lumpy' over time, as I like to say.



Question:

Did you just use the word ‘lumpy’ when describing a company's profitability if it were to expense the total cost of an asset upfront? I love it! How does the practice of depreciating and amortizing assets contribute to a more stable and accurate representation of a company's financial performance?


Yes, I did! But if you think about it, it actually makes sense. Here's an example…let’s say Walmart builds 15 new superstores during one calendar year—those are obviously very expensive to build. If they were to expense the full cost of those buildings in that year, their profit would be reduced significantly for that year. But the following year, they would have those 15 new stores operating and providing significant additional revenues for the company without any expenses against them, so that would in a sense make the profit for that year artificially high. By depreciating those assets, the new buildings, over the useful life of the asset, which in this case may be 30-40 years, the company is matching the cost of those assets with the benefits they receive from them over time, thereby giving a much more accurate view of true profitability.


So, to sum that up, depreciating and amortizing assets contribute to a more stable and accurate representation of a company's financial performance by preventing the upfront expensing of the total cost of an asset. This approach ensures a gradual recognition of expenses over the asset's useful life, preventing abrupt fluctuations in profitability and providing stakeholders with a more consistent portrayal of the company's financial health. Does that make sense?


Question:

Yes, that is extremely helpful! Thanks Monty. Now, tax benefits were mentioned as one of the advantages of depreciating and amortizing assets. Could you talk about how companies can strategically leverage tax benefits through these accounting practices and any considerations they should keep in mind?


The key strategy lies in aligning the depreciation or amortization schedule with the company's overall tax planning. By strategically timing the recognition of these expenses, companies can optimize their taxable income, potentially lowering their tax liability. For example, accelerating depreciation in years when the company has higher taxable income can lead to significant tax savings.


So to condense that…strategically leveraging tax benefits through depreciation and amortization involves aligning the timing and methods of asset expense recognition with the company's broader tax planning objectives. This approach not only contributes to enhanced financial efficiency but also requires a nuanced understanding of both accounting and tax principles.


Question:

Can you provide a real-life example or case study where a company's decision to depreciate or amortize assets had a significant impact on its financial stability or strategic planning?


Certainly! Imagine a manufacturing company that invests in amazing robotic machinery to enhance its production capabilities. In line with the accounting principles that we’ve talked about, the company decides to depreciate the equipment over its estimated useful life, recognizing the expense gradually over several years. This strategic approach aligns the cost of the equipment with the long-term benefits it provides, like increased efficiency, reduced labor costs, and higher production output.


By depreciating the machinery, the company not only adheres to accounting standards but also ensures that the impact on its financial stability is better measured. Instead of a significant one-time expense affecting profitability in the acquisition year, the gradual depreciation allows for smoother financial planning and budgeting. This, in turn, facilitates strategic decision-making regarding future investments in technology and equipment.


The approach not only supports the company's financial stability by avoiding abrupt profit fluctuations but also contributes to informed strategic planning. It enables the management to assess the true cost of the asset over its useful life, factor in ongoing maintenance expenses, and plan for future technology upgrades or replacements. This example illustrates how the decision to depreciate assets can have a substantial and positive impact on both financial stability and the long-term strategic direction of a company.



Question:

Wow, that's great. The useful life of assets is often mentioned when talking about assets. How do companies determine the useful life of their assets internally, and what factors might influence these estimates?


Internally, companies consider various factors when determining the useful life of their assets. Factors include technological obsolescence, expected wear and tear, industry standards, and the specific nature of the asset. Regular assessments and reviews help companies adjust their estimates based on changes in business conditions and technology advancements. However, it’s important to note that there are government standards that must be followed as well. In the United States, the Financial Accounting Standards Board regulates these areas and sets some parameters with which companies must comply.


Question:

And now we'll end on a high note. How does a solid understanding of depreciation and amortization contribute to improved decision-making for businesses, beyond financial reporting, and what role does financial acumen play in utilizing this information effectively?


Oh, this is a great question! A solid understanding of depreciation and amortization is crucial when making informed decisions beyond financial reporting. Financial acumen enables professionals to interpret the impact of these accounting practices on overall business strategy, resource allocation, and profitability. It empowers decision-makers to optimize the balance between short-term financial results and long-term strategic goals, fostering a more holistic approach to managing company assets.



ACTIVITY:

Now that we've talked in depth about depreciation and amortization and how it applies to a business, let's engage in a learning activity you can easily do during your next team meeting:


Exercise: Depreciating and Asset
  1. Start with giving your team a simple scenario involving the acquisition of a tangible asset. Try using something relevant to your company, but you could also use the example of a new building as we mentioned in the Walmart example.

  2. Give the team details like cost, estimated useful life, value, and any relevant tax considerations.

  3. Divide the team into two groups and instruct them to discuss how they would depreciate the asset based on the provided scenario.

  4. Once you’ve given them 3-5 minutes, bring the groups together and discuss their approaches to depreciating the item. Encourage each group to share their rationale for selecting a particular depreciation method and any considerations they took into account.

  5. Highlight any differences or similarities in the depreciation approaches taken by each group and facilitate a discussion around the team’s decisions.



This activity allows team members to apply their understanding of depreciation in a practical scenario, fostering collaboration and critical thinking within the group. By comparing and discussing different approaches, participants gain insights into the factors influencing depreciation decisions and their impact on financial performance.


 
Continue your learning…


Depreciation

vs.

Amortization





How to Analyze

Investments



 
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