WHICH COSTS COUNT?

The willingness to take accounting profits at something other than face value is an essential element of genuinely useful financial statement analysis.

Many of the variations hang on the question of which costs to deduct in deriving the most analytically informative definition of earnings. Although some of the popular variants offer insight into knotty problems of financial statement analysis, others have the opposite effect of obscuring the facts. Many issuers of financial statements attempt to exploit dissatisfaction with GAAP by encouraging analysts to adopt earnings measures that make their own profits appear higher than either their accounting profits or their bona fide profits.

The archetype for most of today’s alternative earnings measures is a version that adds back depreciation. As far back as 1930, an investment ex­pert urged investors to ignore accounting-based earnings in the following words:

Textbooks will advise the investor to look for earnings figures which give effect to depreciation charges. But depreciation, after all, is a purely ac­counting item, and can be adjusted, within limits, to show such net earn­ings as are desired. Therefore it would seem preferable for the investor to obtain, if possible, earnings before depreciation, and to make his own es­timate of depreciation in arriving at approximate net earnings.¹

Observe that the author does not dispute the relevance of depreciation to the calculation of earnings.

It is fair to assume, in the case of financial statements that companies present to potential investors, that “such net earnings as are desired” are higher than the company’s bona fide profits. Therefore, the necessary ad­justment is to increase depreciation and thereby reduce earnings. The au­thor agrees with today’s boosters of alternative earnings measures that proper analysis requires adjustments to reported income, but he is very far from urging analysts to ignore depreciation altogether.

Promoters of many companies with negligible reported earnings, on the other hand, are not bashful about urging investors to disregard deprecia­tion. This audacious assault on the very foundations of accrual accounting draws its inspiration from the world of privately owned real estate, where the logic of managing a public company is turned upside-down. Instead of exploiting every bit of latitude in the accounting rules to maximize reported earnings, private owners of real estate strive to minimize reported income, and by extension, income taxes. Accordingly, when a private investor ac­quires a building (a depreciable asset) and the land that it sits on (which is not depreciable), she typically attributes as large a portion of the purchase price as possible to the building. That treatment maximizes the deprecia­tion expense and minimizes the owner’s taxes.

Let us suppose that annual rental revenue on the building offsets the landlord’s out-of-pocket expenses, such as maintenance, repairs, property taxes, and interest on the property’s mortgage. The owner, in other words, is breaking even, before taking into account the noncash expense of depre­ciation.

Recapping the real estate investor’s experience, she has sold the prop­erty for more than she paid. Her gain has not been reduced along the way by net cash outlays on operations. On the contrary, the tax savings pro­duced by the noncash depreciation expense have contributed to the rise in her wealth. The key point is that the investor is wealthier than she was before she bought the building. According to our definition, she has realized a bona fide profit, despite reporting losses every single year. Adding to the paradox is the investor’s success in selling the property for a gain. Economic theory states that an investment has value only because it produces profits. By extension, the value can increase only if the profits increase. In this in­stance, however, the property’s value rose despite an uninterrupted flow of red ink. (The result calls to mind the observation of two officials of the So­viet Union in the 1939 film Ninotchka: “Capitalistic methods... They ac­cumulate millions by taking loss after loss.”³)

Naturally, these curious events have a rational explanation. The rate at which the tax code allows owners to write off property overstates actual wear-and-tear. Over the typically very long life of a building, it may get de­preciated several times over for tax purposes. The disparity between eco­nomic depreciation and tax-based depreciation may be viewed as a subsidy for socially productive investment. Alternatively, it can be seen as a testa­ment to the real estate operators’ influence over the legislators who write the United States Tax Code.

Either way, a conventional income statement provides a cockeyed view of the profitability of buying and selling buildings. A closer approximation of reality ignores the depreciation expense altogether and focuses on cash- on-cash profit. In the simplest terms, the owner lays out a sum at the begin­ning of the investment and takes out a bigger sum at the end, while also generating cash—through tax savings—during the period in which she owns the building.