Wednesday, September 27, 2006

Straight line depreciation and crooked line depreciation

Depreciation is one concept that allows a lot of creative management to do a lot of creative accounting. They are so creative that when they sit in front of the PC, the sound card leaps out of the motherboard and give them bearhugs.

Just to mention a few ways how depreciation can help make really ugly no.s look like The Swan, here are the popular tricks:

1) Increasing or reducing the depreciation life
2) Using crooked line depreciation
3) Depreciate things that are not supposed to be depreciable

Let's use the previous analogy of Ah Gou, the rogue taxi driver to see how each trick works.

In 1), Ah Gou decides that his taxi (which cost S$1000) can actually last 20 yrs, so assuming he still earns S$200, instead of booking only S$100 of profit, he can now book S$150 of profit, and the value of his taxi only drop to S$950 instead of S$900.

In 2), Ah Gou still depreciate over 10yrs, but he can depreciate the taxi less for the 1st few years, say, $80 for the 1st year, again he can book a higher profit of S$200 - S$80 = S$120. (In real life, usually company front-load depreciation so that subsequent years will look good, or so that they can sell their assets and book profits, like what SIA does with its planes)

In 3), say Ah Gou bought a phone for his personal use, but his clients got the no. and started calling him up to book his taxi. (Ok, mobile phones are not invented yet, but just an example ok?) He depreciate this cost of the phone (S$100) for 10yrs as well, so bcos of the phone, he earns more, say $250, but he only book the total depreciation of S$100 (car) + S$10 (phone) = S$110. And his profits increased to $140.

So as you can see, it is up to creative management and accountants what they want to do right? In the 3 examples, profits was easily increased by 20%-50% ($100->$120, $140, $150). Welcome to the World of Wall StreetCraft, where investors are the lowest lifeform and cannot help but fall into the ubiquitous booby traps.

See also Asset Turnover
and Fixed Asset and Depreciation
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