2007 Accounting Error of the Year: Depreciation and Amortization

Implications: The subject article provides some interesting insights into the upward reversal in the number of securities class-action lawsuits filed during 2007.  Given such, I thought it might be fitting to offer my personal insights into what I continue to believe is the most common, yet rarely noticed, accounting error. As in prior years, inappropriate depreciation and amortization methodologies once again gets my nomination for Accounting Error of the Year.  Unfortunately, absent some unforeseeable improvement in oversight by corporate auditors and the SEC, I suspect that I will again be making the same nomination this time next year.      

Analysis: In the course of reviewing the financial statements of public companies, rarely a day goes by that I don’t encounter inappropriate depreciation and amortization accounting policies and practices.  I suspect that in many instances these inappropriate depreciation and accounting policies and practices are inadvertent given the thoughtless inclination by many accountants to merely default to a straight-line methodology as it facilitates bookkeeping.  However, in many other cases, I suspect that straight-line depreciation or amortization is utilized by managements to inflate near-term earnings.    Simply put, the manner in which a company depreciates or amortizes an asset, whether tangible or intangible, should materially parallel the economic benefits (e.g., revenues, cash, etc.) it realizes from the utilization of such asset.  Unfortunately, companies routinely utilize straight-line depreciation or amortization despite the pattern of economic benefits being other than ratable.  In particular, as the economic benefits realized from a technologically or competitively sensitive asset are often front-loaded and dissipate over time on an accelerated basis, companies should be depreciating or amortizing such asset on an accelerated basis as well so as to provide for a better matching of revenues and expenses.  To do otherwise, which I note is too often the case, results in artificially inflated earnings in the early years and artificially deflated earnings in latter years, compounded by an increasing probability of asset impairments or losses on sales/disposals being recognized downstream.  Accordingly, analysts should attempt to adjust their earnings models accordingly, particularly for any unsupportable disparities among peers.