{"id":54704,"date":"2020-02-11T18:38:26","date_gmt":"2020-02-11T17:38:26","guid":{"rendered":"https:\/\/valuesque.com\/en\/?p=54704"},"modified":"2020-12-15T10:07:57","modified_gmt":"2020-12-15T09:07:57","slug":"northgates-depreciation-game-the-fixed-assets-become-inventories-financial-analysis-problem","status":"publish","type":"post","link":"https:\/\/valuesque.com\/en\/blog\/2020\/02\/11\/northgates-depreciation-game-the-fixed-assets-become-inventories-financial-analysis-problem\/","title":{"rendered":"Northgate\u2019s Depreciation Game \u2013 The \u201cFixed Assets become Inventories\u201d Financial Analysis Problem"},"content":{"rendered":"

Northgate Group Plc. is UK\u2019s biggest provider of light commercial vehicle rental services, with operations in UK, Spain and Ireland. Its business model is relatively straightforward. The company acquires the vehicles, rents them out over a certain period and sells them at the residual market value at the end of the renting phase.<\/p>\n

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Source: Northgate, Financial Year 2019 Results, Presentation, Slide 22.<\/p>\n

While in pure cash-terms this is a business like many other businesses, in accounting terms it shows some special characteristics. The tricky aspect here is that the vehicles change their accounting nature over time. First they are fixed assets which generate rental income, and after that they are inventories that are sold to end-customers. But once these vehicles become inventories they have already a relatively long life of action behind them. So, the question arises what a proper accounting value path of these vehicles is over time. And if we ask about accounting value paths of assets, we have to talk about \u201cdepreciation\u201d. And in fact, for Northgate the treatment of the depreciation policy is clearly the crucial point for understanding the profit generation process.<\/p>\n

In theory, we know very well how an appropriate depreciation schedule has to look like in order to allow for a proper performance measurement. The so called \u201crelative benefit depreciation\u201d technique (see e.g. Reichelstein (1997): Investment Decisions and Managerial Performance Evaluation, in: Review of Accounting Studies, 2, p. 157\u2013 180) ensures that periodical value changes of assets follow an economic path and lead to an unbiased profit determination. However, this technique requires a forward looking accounting value determination (in contrast to our usual historical cost based accounting value determination) which more or less leaves this technique an academic exercise which is not reasonably applicable in accounting practice.<\/p>\n

Hence, in reality we rather see simplified value development paths such as those based on the straight-line depreciation schedule. Such proceeding is perfectly understandable from the view point of practical application but it is worth to understand the limits and problems of it and why certain business models \u2013 such as Northgate\u2019s \u2013 are particularly prone to these problems.<\/p>\n

We start our analysis by first having a look at how companies which offer such a split-business of both renting and selling generate profits (it is enough here to look at the operating profit generation). For the start, the numbers in these examples are just simplified hypothetical numbers for illustration purposes (but this will change later). Imagine a company rents vehicles over a period of 5 years after they are bought (original acquisition price per vehicle: 100 \u20ac) and then sells these vehicles for 50 \u20ac each after these five years. For the rental services the company generates revenues of 50 \u20ac in each of the first 5 periods. The company anticipates the future selling price correctly, depreciates the vehicles over 5 periods with an expected salvage value of 50 \u20ac at t=5 (i.e. on a straight line basis the depreciation charge is 10 \u20ac each year). In our example no other operating costs are included.<\/p>\n

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As we can see, this company earns a profit of 40 \u20ac each period for 5 years (totalling 200 \u20ac over the 5 years). The selling of the vehicle is profit-neutral as the selling price equals the residual book value in period 5.<\/p>\n

Now imagine the company uses a different depreciation schedule. Still straight-line, but now a full depreciation down to zero over 5 years. Might be that this is done because the company does not know the future market selling price before (and thinks it is zero at inception of the depreciation schedule, i.e. at t=0) or might be that this is done on purpose \u2013 just using the leeway that depreciation rate setting entails. Anyway, now the table looks as follows.<\/p>\n

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Now the periodical depreciation charge is 20 \u20ac, the first years\u2019 profits are accordingly lower, but due to the heavy accounting value reduction over time the company can generate a decent profit on the sale of the vehicle (50 \u20ac selling price vs. 0 residual accounting book value at this time). Important: In total the company still earns 200 \u20ac over the 5 year period.<\/p>\n

The consequence of this implicit shortening of the useful life of the vehicles is obviously a profit shifting or more concrete here a back-loading of earnings for a single vehicle project. As the company perhaps runs more than just one car this development might somehow get smoothed a bit. But if the company is in a growing state this back-loading would result in a periodical reduction of earnings as compared to the initial case presented here. Of course, going the other direction (i.e. lengthening the accounting useful life of vehicles by reducing the depreciation charge in the first periods) would lead to the opposite effect: First periods show a higher profit, and year 5 shows a lower profit as the company would record a loss on the sale. Hence, in a growing state lengthening the accounting useful life leads to an increase of periodical earnings.<\/p>\n

This effect is well known and we have already discussed this issue in one of our blog posts (HERE<\/strong><\/a>). But this is not the real magical trick that companies can do with such a split business (renting and selling). The real interesting case goes a bit deeper.<\/p>\n

For the further discussions we first have to have a look at what happens if a company thinks that the historical useful life assumptions are no longer valid but have to be changed. In this case IFRS tell us that the carrying book value at the date of when the company changes its estimate about the useful life is not changed<\/u> but this carrying book value is now depreciated in future periods according to the new useful life assumptions (IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors<\/em>). E.g. for a vehicle (still: original purchase price: 100 \u20ac) that has been depreciated over 2 years assuming an original 5 period useful live (salvage value: zero) which at the end of period 2 is assumed to have a useful life of rather ten years (or a salvage value after five years of now 37,5 \u20ac) the accounting path would look as follows.<\/p>\n

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It is understandable from a practical point of view and from the basic conception of IFRS that no restatement of the carrying value at the beginning of the estimate change takes place, but it is worth highlighting here that this proceeding is quite different from the theoretical ideal of the above discussed relative-benefit-depreciation schedule (because when the useful life of the vehicle is in fact 10 years than the historical depreciation charges have been too high, i.e. the carrying book value according to IFRS overstates the fair carrying book value in an ideal accounting system). However, this is the accounting system financial analysts (and companies) have to deal with.<\/p>\n

Now, what does this mean for the profit generation of the company over time? We have a look at a hypothetical company which is in a no-growth state but runs several vehicles such as the one in our example above \u2013 more concrete: each period the company buys one vehicle, rents it over 5 years and then sells it. From a pure operational point of view the company is in a steady state.<\/p>\n

As long as the company does not change the estimate of the useful life, and with the know-how of our analyses above we can see that in this case it does not matter for total earnings whether the company assumes a salvage value of 50 \u20ac after 5 years or a zero salvage value after 5 years. However, the distribution of where these earnings come from differs between these two cases (no earnings from selling the vehicles in the first case and 50 \u20ac per period for selling one vehicle each period in the second case).<\/p>\n

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Comment: In the \u201c50 \u20ac salvage value\u201d case earnings are the result of 5*50 \u20ac rental income minus 5*10 \u20ac depreciation (steady state), and accordingly in the 0 \u20ac salvage value case.<\/p>\n

And now it gets interesting: What happens with the earnings if the company decides on the way that the original useful life or salvage value assumption is no longer appropriate but that it has to be changed (a change in accounting estimates). We look at the case where the company increases the useful life assumption (or equivalently increases the salvage value assumption, both are the same from an economic point of view). Let\u2019s look at the profit development for two different cases of such changes: a) a sudden increase from zero salvage value to 50 \u20ac salvage value, and b) a gradual increase from zero to 50 \u20ac salvage value in 10 \u20ac steps per period. The change of estimates happens in period 4.<\/p>\n

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This is a quite interesting picture! Obviously with changes in estimates a company that runs such a split rental-selling business can push its earnings, it can create earnings seemingly out of nowhere \u2013 at least for some time! Why is this the case? Some comments are necessary:<\/p>\n