Castles in the sky

How depreciation expenses affect earnings

August 15, 2016

About the author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Between 2010 and 2020, Ganel worked for Silvergate as Vice President in Capital Markets. He provides advisory services to family offices,  private companies, and financial advisors.

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‍“Trumpeting EBITDA is a particularly pernicious practice,” notes Warren Buffet, boss of Berkshire Hathaway. “Doing so implies that depreciation is not truly an expense, given that it is a ‘non-cash’ charge. That’s nonsense.”

Moreover, depreciation charges often result in lower reported earnings and real estate values. Because the depreciation charge is deducted from revenue, lower earnings are reported. And because real estate value, as carried on the books, are inversely related to the accrued depreciation account, real estate values decline as well.

There are opposing schools of thought on the benefits of hefty depreciation charges. On one hand, lowering taxable earnings results in lower taxes payable each year, which is viewed favorably by some. On the other hand, the decline in real estate value translates to higher capital gains taxes when the real estate property is later sold. But there is an agreement on one matter. 

A lesser amount of dividends are distributed to the real estate investors because of dear depreciation charges. The table below shows the difference between reported earnings and available earnings. The difference in earnings reported is a result of lower capital expenditure expense compared to the depreciation charge. An illustration for a capital expenditure is the replacement of a roof or an elevator.

In past five years, the company depreciated its real estate value by $2,496,000, but actual expensed cash was $841,000. As a result, the five year average of net loss of $40,000 should have included the unspent amount of $415,000. And the cash increase should have augmented the working capital account or been distributed as dividends to the real estate investors.    

At its core, the concept of depreciation expense is rooted in the matching principle, notes Travis Long, an accountant. How successful the application of the theory is questionable. The venerable investor said it best: “Not only is depreciation an actual expense, it is also an unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.”

In short, your dividend distribution is dependent on the depreciation charges taken by the company. By comparing the depreciation charge to what the capital expenditure expense brings, a greater sense of economic reality is achieved.