Real Depreciation
January 6th 2007 10:06
Depreciation is a much misunderstood thing. If you know accounting, you’ll know that depreciation is an amount you charge in the books against revenues so as to offset the purchasing price of an asset item. So far, fine.
If you buy a new machine for your manufacturing business you should be able to charge the amount paid for it against revenue in several yearly portions. This is fair and results in your net profit before tax being smaller for the year and so also your tax payable.
The taxation office then creates a series of requirements for depreciation and I think that at a certain stage people lost sight of what depreciation really entails, other than being a mere book entry.
In practical terms, you have to put an amount of capital money aside every year for plant and equipment expenses. Your machinery needs repairs and maintenance, it needs replacement after a few years of use and so on. Where does that money come from?
Years ago, in the US, they made a statistical study of a large number of companies and they found out that, for most of them, depreciation expenses, overtime, paralleled capital expenditure. What does this mean? That the amounts taken in depreciation as mere book entries, were in fact spent in plant and equipment or other.
This is relevant because in the last decade it became popular to evaluate a company’s ability to borrow by comparing its earnings before interest, tax, depreciation and amortisation (EBITDA) with the interest expense.
Obviously, if you think of depreciation as real, then that concept of earnings will be telling you that you have more money to spend than you actually have, which looks dangerous.
And this is the trick with real depreciation.
If you buy a new machine for your manufacturing business you should be able to charge the amount paid for it against revenue in several yearly portions. This is fair and results in your net profit before tax being smaller for the year and so also your tax payable.
The taxation office then creates a series of requirements for depreciation and I think that at a certain stage people lost sight of what depreciation really entails, other than being a mere book entry.
In practical terms, you have to put an amount of capital money aside every year for plant and equipment expenses. Your machinery needs repairs and maintenance, it needs replacement after a few years of use and so on. Where does that money come from?
Years ago, in the US, they made a statistical study of a large number of companies and they found out that, for most of them, depreciation expenses, overtime, paralleled capital expenditure. What does this mean? That the amounts taken in depreciation as mere book entries, were in fact spent in plant and equipment or other.
This is relevant because in the last decade it became popular to evaluate a company’s ability to borrow by comparing its earnings before interest, tax, depreciation and amortisation (EBITDA) with the interest expense.
Obviously, if you think of depreciation as real, then that concept of earnings will be telling you that you have more money to spend than you actually have, which looks dangerous.
And this is the trick with real depreciation.
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