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Blog and News

Steve Bartoletti

Depreciation is unreliable

Posted By: Steve Bartoletti on 12/15/2015 3:27:22 PM, 0 Comments, 16825 views
In response to my article: Negative Working Capital is not Negative, I have received emails pointing out problems with depreciation expense, and questioning the efficacy of CPFA since CPFA is "next year's depreciation expense." Following is extracted from my response to the most recent such inquiry:  

First, you are absolutely correct that “CPFA” is no more reliable than the accounting for depreciation.  And there are problems with depreciation. I have just responded to another inquiry from a banker who points out that under some circumstances, small businesses can deduct 100% of a fixed asset in one year! If we only have cash basis tax statements to work off of, that’s a problem. The case you mention is similar—where depreciation dropped so much from one year to the next.. (maybe the depreciation on a major fixed asset ran out or the asset was sold?)  It is curious and suspicious.

However, depreciation is an issue within accounting in general. Although it similarly affects the usefulness of CPFA, it is not unique to CPFA.  Issues about depreciation plague us as analysts already--anywhere that it comes into play, be it in the cash flow statement or in some form of DSCR (debt service coverage ratio). You are correct that if depreciation fluctuates abnormally, last year’s depreciation is not a good surrogate for CPFA. All the more reason that companies should report CPFA because it correctly matches NEXT year’s scheduled depreciation expense with next year’s loan payment (CPLTD). 

As for the calculation of CPFA, we as analysts don’t have the data, but the company does. All fixed assets are booked with a depreciation schedule, so it would be very simple for the company to tally the depreciation scheduled for the coming year for all fixed assets. (For clients with good accounting systems we could ask the controller for the number.) 

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