accounting question

I asked this question before a few weeks ago and got an unclear response. I’ve been thinking about it more and figured out a new way to ask it… so here goes: On an individual asset (say a sewing machine), it seems logical that you make an assumption about the average life of that asset by dividing the depreciation expense for that asset by the capex (cost to acquire that asset). Here’s the part I’m kind of having trouble with: is it logical that you can *for rough estimation purposes* guestimate the average life of a company’s assets *in total* by dividing their ongoing (normalized?) depreciation expense by their ongoing capex budget? Is that too much of a stretch?

What you are saying makes sense, but how far off your estimate is will purely depend on the type of company and the type of assets. If you have a cement manufacturing company with 2 plants costing 10 million in total and depreciated over 40 years, and 20 trucks depreciated over 10 years worth 2 million your estimate will be skewed based on the value/depreciation of the plants, hence it will be wrong. I’ve never seen this done in practice either.

Ok… I get you but would it be safe to say that the average dollar of capex is depreciated over X years based on a dollar weighted blend those two groups of assets?

well, depreciation expense will come from the depreciation for federal tax purposes, and assets have certain tax lives and are usually not depreciated using s/l. for example, a sewing machine for a dry cleaning company would be an asset used in distributive trades and services, and will be subject to a 5-year MACRS life (200% decling balance)under GDS

no, tax depreciation can be and is often VERY different from gaap depreciation on a financial statement.

yes, GAAP and tax is very different, i may have read the question wrong, i am pretty tired. I thought u were forecasting cap ex for a DCF

not sure how you think of capex/d&a for a particular asset, but a lot of times when you’re forecasting d&a and capex in an operating model or an LBO model, it’s a convenient and simple assumption to look at d&a as a percentage of capex. in a base case scenario for an LBO model, it isn’t uncommon to forecast d&a equal to 100% or less as a percentage of capex. you do this because while you don’t know exactly what the company will do post-buyout, at a minimum you figure the company will have to spend at least as much on capex to cover the depreciation on the LT assets in its books, and often more so because you can’t really grow revenue growth without plowing back money into capex anyway, not sure if this answers your question from the “accounting” perspective but this is how you often see it from a modeling perspective

ahh, i see. i don’t deal with LBO models, alot of my work is in capital intensive industries (energy & power) so we try to forecast Dep as accurately as possible

I’m not trying to forecast it… I’m trying to come up with an argument to adjust past depreciation to make the book value higher (don’t ask me why).

If you want an argument, then i suggest you look at the depreciation methodology outlined in the notes of the financial statements and build an argument that is based on the right methodology should’ve been a more conservative depreciation policy.

the only way i can see how you can decrease past depreciation to how a higher bv, is if you reevaluate the life of the assets, saying that the earlier estimate was too conservative (shorter life of assets leading to higher depreciation), and that now, youd like to undo that. from what i remember, a change in estimate is a below the line adjustment and below NI, so that it affects shareholders equity (increasing it) but not NI (stays the same).

virginCFAhooker Wrote: ------------------------------------------------------- > no, tax depreciation can be and is often VERY > different from gaap depreciation on a financial > statement. yep, thats where all them deffered tax assets/liabilities you studied in level one originate. Bm i didnt know that you could make those sort of adjustments dosn’t it violate the conservatism principle to recognize what is in effect a gain?

read the reason why he’s going down this path: “I’m not trying to forecast it… I’m trying to come up with an argument to adjust past depreciation to make the book value higher (don’t ask me why).” …clearly the conservativism principle isnt of issue here…

bm_chicago: A change in estimate, e.g. depreciation method, useful life, is applied prospectively and therefore is not a “below the line” adjustment. numi: I’m not sure forecasting D&A as a % of Capex is an assumption about Capex as much as it is an assumption about D&A.

VOBA, i agree, and thank you … a change in estimate should affect NI, but a change in principle (type of dep method, etc) should be reflected as a retrospective application and an adjustment to the opening retained earnings balance. again, i am no expert so any clarity is appreciated.

right but the base case numi was talking about is a simplifying assumption that makes deprc and capx offset one another from a free cash flow perspective, so it doesn’t really matter which one drives the other in terms of the model. Theoretically you assume the company’s capital investments are planned solely to keep its plant and equipment from obsolescence, and therefore the non-cash depreciation add back cancels out the incremental capx. I think the cfa definition of average asset age is accumulated depreciation / depreciation expense.

Big Nodge… do you mind telling me where you found that definition? Also, what do you think about defining the average life of all assets as capex/depreciation?

virginCFAhooker, the formula for: average asset age = accumulated depreciation / depreciation expense comes from 2006 CFA readings, it is probably in this year readinsg as well. There is a caveat to this formula that the calculation can be distorted by changes in asset mix and by acquisitions. Few more relevant formulas average depreciable life = ending gross investment / depreciation expense (this calculation is also a rough approximation as it can be affected by changes in asset mix) relative age (as % of depreciable life) = accumulated depreciation / ending gross investment (this is an accurate estimation, as long as straight-line depreciation is used, however the accelerated deprecitaion methods invalidates this analysis)

It’s funny, I cover financials so I never think about this stuff, but I was recently modeling a company with a large operating lease portfolio so I had to remind myself what depreciation was all about. I remembered the definition from the cfa so I pulled out my Schweser Level I notes and there it was. I used it in my model, disclosed as an estimate. The company I was looking at applies straight line depreciation consistently to a fairly homogenous portfolio so I figured it was a decent approximation. So as to your other question, are you trying to calculate the average AGE of the assets or the average LIFE of the assets? The CFA definition addresses age, but it seems like your calculation is looking at average useful life. Even so there are a few issues, mainly that it ignores any assumptions on salvage value. So assuming the asset has some residual value, your calculation will overstate the average life of the asset (which is what you want to do I imagine, and it’s not necessarily good practice to chose a method that by default tells you what you want to hear). The other problem is using your ongoing capx might distort things based on inflation and change in capital spending mix. If a company suddenly ramps up its capx dramatically it will effect your calculation but won’t necessarily change the appropriateness of prior period depreciation expenses. But like I said this isn’t my area of expertise by any means.

Big Nodge, thanks for the formulas. It’s not my area of expertise either. Here’s how I was playing with it… I was pitching a stock as a pure “value” idea, where the net tangible book value is a very important aspect of the valuation. I looked at the long term running capex & depreciation and said that depreciation was too high relative to capex (too high for a company that buys real estate, engages in low tech manufacturing, etc.). I argued that based on the high % of capex, management is saying their assets only last 2 years. I then adjested the current ppe based on what it would look like if assets lasted longer than 2 years (i.e. depreciation a smaller % of historical capex)… the net tangible book value was much higher and I had my big discount I wanted to show it was a classic “value investment”. Afterwards, I felt like I made too many assumptions but oh well.