Capitalization and Depreciation Explained

 

What would you say if I told you that there are companies out there who incur costs, but don't report the amounts on their income statement. Meaning that there are costs excluded from their net income number. You might say well, that sounds like fraud and in some cases you'd be right. But what I've described happens all the time in the world of finance through a process known as capitalization. Capitalization, which is not to be confused with market capitalization, is a process whereby a company spends money and delays the recognition of an expense using what's called depreciation. to eventually show the cost of the item on the income statement. The whole concept makes sense when you go through the logic behind it. 

But both capitalization and depreciation numbers have been subject to manipulation by management in the past. So before you have too much weight to a company's net income members. let's go over capitalization and depreciation.

 At first glance, the concepts of capitalization and depreciation may lead you to lose all faith in the entire accounting system as you know it. Because at its core it causes two very strange outcomes. Firstly, it causes the income statement of a company, which is the summary of a firm's annual performance to completely ignore some very material costs, at least initially. This means a company may spend more money than it's making in a given year and still report a positive profit. The second outcome caused by depreciation is strange to some expenses that are on the income statement, are non-cash. means that the company didn't actually pay the amount listed that year. So we are left with net income numbers that ignore some expenses and make others up. But don't worry there is a method to this madness and probably the easiest way to explain it is to go through an example.

 Imagine you're running a lemonade stand and you hear about this new piece of machinery, the lemon squeezer 5000. It's a cutting edge piece of equipment that you believe, will help you increase your lemonade production tenfold. So you buy the machine. There's just one issue the piece of equipment costs $2,000. a pretty high expense for your small operation. So even though you believe it will pay for itself over time, it's gonna leave a solid dent in your bank account. Now if you're a lemonade stand filed an income statement, your first instinct may be to include the full cost of your lemon squeezer 5,000 as an expense. This would cause a noticeable drop in your net income for the year you bought the machine. But that's not necessarily fair.

 why? Well first of all the piece of equipment isn't something you're just gonna use in one year. It's something that may help you boost your productivity for several years into the future. On top of this you could argue that while you paid enough money for the machine you didn't technically lose any wealth you've simply made a big investment. And now your wealth that used to sit in cash is in your lemon squeezer five thousand. In fact maybe the lemon squeezer 5000 is in high demand and you determined that you could actually resell it in the future near its full price. So you really haven't lost the two thousand dollars you paid for the machine, you've just placed it into another asset. This is the essence of capitalization.

 Capitalization takes an expense and recognizes it as an asset. basically, arguing that the money you spent for it isn't lost just locked up in a piece of equipment or plot of land or some other asset. The outcome of capitalization is that, the expense doesn't show up in the income statement. and be the company's balance sheet will show a decrease in cash and an increase in machinery. Showing the transfer of money into the investment. But this might not seem entirely fair either. Sure you may not want to expense the whole lemon squeezer 5000 in year one. But the piece of equipment won't last forever. Eventually through wear and tear the machine is going to lose its value. So at some point you'll have lost at least some wealth on the purchase. In fact maybe you ascertain that the lemon squeezer 5000 only has an expected useful life of ten years, after which it will become useless and worthless.

 So we don't want to ignore this loss of value that we're going to experience and this is where the concept of depreciation comes in. Depreciation allows you to recognize the expense of an item over time, reflecting the assets gradual decline in value. Let's go back to our example. Let's say you buy the lemon squeezer 5000 for $2,000, and you were confident that the machine will last you 10 years, after which it will become worthless. To reflect this in your income statement you could use what's called straight-line depreciation. Whereby every year you recognize $200 of expense on your income statement, which is equal to the $2,000 cost divided by 10 years. this expense would roughly show the loss of value you experienced with your machine over time. St's sensually assuming that after one year you could sell your machine to someone else for $1,800 and after 2 years you could sell it for $1,600 so on and so forth.

 So with depreciation we can reflect the loss of value in our assets, which is a useful way of depicting a company's financial situation. If company is making a lot of money but it's equipment is losing its value, then this would reflect in net income, so you can recognize the loss of asset value being experienced against the money the company's making. There are some issues with depreciation, capitalization however. namely, that both depreciation and capitalization rely on a series of assumptions and estimates, many of which may not turn out to be correct. or worse yet they may be purposely manipulated by management. 

For example, with your lemonade stand a key assumption is the useful life of your machinery. But if you increase your machines life expectancy to 20 years, you would reduce your expenses in the short term by spreading out the cost over a longer period of time. Even if this isn't an accurate assumption, this mechanic allows management to influence the bottom lines of their income statements. If they need a short-term profit they may become laxer with their assumptions. Even if management honestly attempts to reflect their financial situation, this is a chance that the assumptions may not work out and you could end up experiencing what's called a write down. Which is like a one-off depreciation expense, that reflects the deterioration of company's assets past what was expected. And it's not a good thing. Often leading to a pretty heavy drop in a stock's price.

 The issue gets even stickier when you deal with more intangible things like R&D, research and development. You see the expenses behind research and development can actually be capitalized as well. For example, imagine that for your lemonade business, you spend $200 on spare lemons to practice you're squeezing technique. And you find a way to improve the yield of the lemons twofold. Sure you spend $200 to discover this, but what if you could then sell the technique to other lemonade stands making back some of the money you spend. This is the idea behind capitalizing R&d. and it creates what's called an intangible asset, that can be depreciated over time though depreciation for intangible items is known as amortization. The issue with intangible items is that, they rely even more heavily on assumptions. Which again can be manipulated by management. Who's to say how valuable your lemon squeezing technique is is it gonna be worth $10, $1,000, nothing.

 Clearly there are some shortcomings with the capitalization and depreciation processes. It's not that companies are incorrect in using them, but they do muddy a company's net income number. Which would make it more difficult for an investor to analyze a business's underlying performance, year to year. Luckily there are a few things you can do to circumvent the complications that depreciation and capitalization add to the mix.

 Firstly you can look at a firm's ebita number which is their earnings before interest tax depreciation and amortization. It doesn't include all expenses and there are some issues with ebita itself. But comparing ebita from year to year may provide you a better idea of the company's underlying profitability trends, then relying on net income numbers. Alternatively, you can look at a firm's cash flow statement. Here the cash flows from operations will show you how much money the firm is actually making from its business, ignoring non-cash items like depreciation. and the cash flows from investing will show you how much money the firm spent on equipment acquisitions and other items like that. We should also look into a company's capitalization and depreciation policies and the amount of expenses. If the firm is capitalizing a higher rate of capitalization with mediocre revenue growth, It may be a red flag. So as you can see it's unwise to take a company's net income number at face value. While it may provide a quick glimpse at the firm's financial performance, you'll need to check the company's cash flows and accounting policies to get the full picture. 

Thanks for reading if you have any feedback or topics you want me to cover in  the future, leave a comment down below.