A blog I read did a post on goodwill. The discussion there was about economic goodwill. I’d like to talk today about accounting goodwill – that is, intangibles. Technically: accounting goodwill applies only to intangible assets that can’t be separately identified. In other words, “goodwill” is just the catch-all bucket accountants put what’s left of the premium paid over book value that they can’t put somewhere else.
For our purposes though, accounting for specific intangible items is often more interesting than accounting for general goodwill. That’s because specific intangibles can be amortized. And amortization can cause reported earnings to come in lower than cash earnings.
The first thing to do when confronting a “non-cash” charge is to figure out if it is being treated equally or unequally with other economically equivalent items.
I’ll use a stock I own, NACCO (NC), as an example. As of last quarter, NACCO had a $44 million intangible asset on the books called “coal supply agreement”.
The description of this item (appearing as a footnote in the 10-K) reads:
“Coal Supply Agreement: The coal supply agreement represents a long-term supply agreement with a NACoal customer and was recorded based on the fair value at the date of acquisition. The coal supply agreement is amortized based on units of production over the terms of the agreement, which is estimated to be 30 years.”
All of NACCO’s customers are supplied under long-term coal supply agreements which often had an initial term of 30 years. These agreements are economically equivalent. However, one of the agreements is being treated differently from the rest.
The amortization of this coal supply agreement is probably meaningless.
Because: if NACCO acquired a company that had a 29-year coal supply agreement in place, it would record this item on its books as an intangible asset and it would amortize it over the life of the contract. But, if NACCO itself simply signed a coal supply agreement with a new customer – no intangible asset would be placed on the books. And there would be no amortization. What’s the difference between creating a contract and acquiring a contract?
There is none.
Now, that doesn’t mean the economic reality is that NACCO’s earnings never need to be replaced. Many of the contracts NACCO has in place only run for about 13-28 years now. And, far more importantly, the power plants NACCO supplies with coal might close down long before their contracts expire. So, earnings really will “expire” and need to be replaced. But, this has nothing to do with whether a certain coal supply agreement is or is not being amortized. The amortization charge is irrelevant. But, the limited remaining economic lifespan of NACCO’s customers – which isn’t shown anywhere on NACCO’s books – is relevant.
Therefore, two adjustments need to be made. One, amortization has to be “added back” to reported EPS to get the true EPS for this year. And, two, that EPS number has to be considered impermanent.
Depreciation (Unlike Amortization) is Usually a “True” Expense
A depreciation charge is used to smooth out the expensing of an initial cash outlay (the purchase of a long-lived asset) so that the timing of expenses and revenues match.
Depreciation charges are not used to pre-expense the purchase of a replacement asset.
Depreciation charges are only used to post-expense the purchase of an asset now in use.
Because of inflation, a replacement asset will almost always cost more than the original asset.
Therefore, depreciation expenses – unlike the amortization expense above – are not only economically necessary, they are also almost always insufficient to fund the replacement.
As a rule, the annual depreciation expense you see at a company – like the Carnival (CCL) example I will give below – “underfunds” the amount needed to replace the asset. In other words, the more depreciable assets appear on a company’s balance sheet – the more that company’s earnings are likely to be overstated.
A change in the assumptions a company uses to calculate depreciation will change reported earnings. Here is a cruise line, Carnival, explaining how a small change in depreciation assumptions can cause a large change in reported earnings:
“Our 2015 ship depreciation expense would have increased by approximately $40 million assuming we had reduced our estimated 30-year ship useful life estimate by one year at the time we took delivery or acquired each of our ships. In addition, our 2015 ship depreciation expense would have increased by approximately $210 million assuming we had estimated our ships to have no residual value at the time of their delivery or acquisition.”
Carnival’s depreciation assumptions are generally reasonable. The company always overstates its economic earnings, but only because of inflation. Management is not gaming either the estimated useful life of a cruise ship to Carnival (30 years) or the fact that cruise ships have residual value after the initial owner is done with them. There really are buyers for retired Carnival cruise ships. So, each ship has a residual value. There is nothing unusual about these assumptions.
Can Depreciation Ever Be an Exaggerated Expense?
There are, however, company’s that make unusual assumptions. Gencor (GENC) is one such company.
In the company’s 10-K, “Note #4” reads:
“Property and equipment includes approximately $10,645,000….of fully depreciated assets, which remained in service during fiscal 2017…”
This is significant, because the total amount of “property and equipment, net” is shown to be $5.7 million.
Move Up the Income Statement
Distortions caused by accounting assumptions usually appear lower down in the income statement. So, an investor who is worried about misleading expenses can use an item like EBITDA instead of net income. This takes out the complications of assumptions and one-time items related to interest, taxes, depreciation, and amortization. If EBITDA seems high and net income seems low – you want to investigate where that EBITDA is disappearing to. Are these real depreciation charges? Are these irrelevant amortization charges?
The Earnings You Care About Come in the Form of Cash
The key question to ask about any accounting item is whether it will eventually become a cash charge.
To an accountant: whether a company paid cash for the asset in the past matters. For an investor: only whether a company will ever have to pay cash again in the future matters.
Carnival is going to buy more ships each year. It spends billions doing that. So, while you own the stock, cash is going to be headed out the door and ships headed in the door.
The same thing would be true if NACCO’s business really consisted of buying existing coal supply contracts. If, while you owned the stock, your expectation was that NACCO would be using cash to purchase intangibles – then, that amortization charge would make a lot more sense as an ongoing expense.
In reality, the company probably isn’t going to be buying more intangibles while you own the stock. And: earnings from supplying coal to existing customers will “expire”, but it’ll be the shut down of the power plants – not the expiration of the contracts – that causes this.
You always want to focus on economic reality rather than the accounting treatment. So, you want to think in terms of how much cash Carnival will spend buying ships rather than how much depreciation expense it will report.