A CFO's Guide to Depreciation vs. Amortization

This video is a CFO's guide to depreciation versus amortization, and the reason why I'm making this video is that typically accountants understand the mechanics, while good accountants understand the concepts, but only finance leaders and CFOs really get the implications, which we'll talk about here at the end of the video. So if this sounds like something you're interested in, let's dive right in. Hey guys, welcome to another video with your favorite financial controller, Bill Hanna here, with about 20 years of experience in corporate accounting and finance. And I teach my experience here on YouTube, and you can also find my lectures on my best-selling courses, the Controller Academy and the FP&A Academy. Okay, so today's topic is the CFO guide to depreciation and amortization. The real intention from this video is to get to the insight and the strategy part. But I feel before we talk about that, we need to talk about some of the concepts that are the foundation behind depreciation and amortization. What do I mean by that? I mean things like understanding the recording on the income statement, one-time charges, the recording on the balance sheet, and the cash flow statement. Okay, so let's begin. When we're talking the asset related to depreciation versus amortization, the asset when it comes to depreciation is always a tangible asset. So a tangible asset is a truck, equipment, a computer, a server, a building, things like that. Uh, when we're talking amortization, we're talking an intangible asset. An intangible asset is an asset that you cannot touch, and typically an example is a software license or a patent, a brand, a customer list, to list a few things. Uh, the way that we get an intangible asset— there are typically 3 ways that a company gets an intangible asset. Purchased, if you purchase a software license, for example. Internally developed, sometimes you develop internally a software and you capitalize that and that becomes an asset. M&A activity, merger and acquisition. In these cases, one business acquires the intellectual property and intangible asset of the other business. So these are the 3 typical ways that you get an intangible asset: purchasing, internally developing, or M&A activity. Okay, let's talk about the recording of depreciation versus amortization. So when we purchase or develop an asset that is tangible or intangible, typically it happens in a lump sum payment, which we call the historical cost, right? But when you record that on the income statement, you don't record it in one period, you record it over multiple periods. And that is because of what we call the matching principle. The matching principle is one of the basic principles in accounting that says that you have to match the expense that you record with the benefit that you get from that expense, right? You can also explain this as saying matching the expense you incur with the revenue that the expense helped generate, and you'll be correct either way. Expense and benefit, expense revenue generation— that is the matching principle. And that is why we record that on the income statement, depreciation and amortization over a number of of years. Now, the recording that we do for depreciation represents the physical wear and tear. So think of an example of a truck that has a useful life of about 10 years. The wear and tear every year as the value of the asset depreciates is what you record, uh, every single year. Now, what you record for amortization for intangible asset isn't the physical wear and tear, but more of the consumption of the economic benefit of that intangible asset. In the case of an intellectual property, so you acquire a patent for an invention, for example, you then estimate how many years the economic benefit that will be, say 15 years. Then you divide the costs of that over 15 years and you get your annual amortization for that intellectual property. In terms of the number of years, how do we determine the number of years to amortize or depreciate the asset over? That's going to differ from tangible versus intangible assets. So for tangible assets, for example, here in the US, there is the FASB, the Financial Accounting Standard Board, and that is an independent organization that gives you a range for the number of years you should amortize an asset over. Also, if you're enjoying this video so far, go ahead and hit the like button because that is the only way for me to know that you enjoyed the video. Now, what about the number of years to amortize an intangible asset over? That's going to be case-by-case basis. So for example, if you purchase a software license that covers 5 years, then you'll be amortizing that over 5 years. If you are getting a patent, you will have to do a study and see how many years the economic benefit of that patent that you can support. If you can support 10 years, then you amortize that over years. The important thing is to have some kind of evidence, contractual evidence, or a study that supports the number of years that you are amortizing over. Now, when we're talking about recording, are we recording depreciation in COGS or operating expenses? Well, it could be either, and in many cases it's both, right? So what is the criteria? The asset that you're using for production, the depreciation of that will go into COGS. So think of the equipment that you're using to manufacture the product that you're selling, or the factory building itself that you are depreciating. The depreciation of that will go into COGS. What will go into OpEx, for example, is going to be the supporting function. So if we're talking about the office building where the accountants and the lawyers and the selling and marketing people are sitting, that is not related to the production of what you're selling, but that is the supporting functions. So the depreciation of an office building, that will go into operating expenses versus COGS. Now, on the intangible side, things like software that you develop for resale, if you're developing a software and you're capitalizing that and the intention is that you're going to resell it, The amortization of that is going to sit under COGS. The same way, if you are getting an intellectual property or a patent for the purpose of production of a product that you will sell, the amortization of these things will sit under cost of goods sold. Now, what will go under operating expenses in terms of amortization? Well, these are things like software license. If you get a 3-year or 5-year software license, The amortization will sit under OpEx, given that the function of that software isn't the production of what you're selling to customers. It's just the support of the business, right? Things like customer list, also that will get amortized under operating expenses. Understanding the distinction of whether depreciation, amortization fall in COGS or OpEx becomes really important for you as a finance leader because it determines gross margin analysis. EBITDA interpretation and segment profitability if you have multiple segments in the business. Okay, we also have one-time items that could be sneaky and it could be large that hit your income statement, and you have to do when it comes to tangible assets with obsolescence and damaged equipment or whatever you have as a tangible asset or a truck you may have sitting in your lot and it doesn't work, it doesn't function, it's either obsolete or damaged and and when you take inventory of your tangible assets, you realize that you have this item that you have to write off of your books, and that could be a large one-time charge to your income statement. So we need to be mindful of that and take an inventory of your tangible assets. And for your intangible assets, your one-time charge could be an impairment. So that typically relates to assets that you acquire through M&A activity, like goodwill, for example, that has indefinite life. So you don't have a specific life that you can amortize it over. Instead, what you do is you do an impairment at the end of each period to determine whether the good— the goodwill that you got still has the same value that you said it has at the time when you did the M&A, right? So that's a one-time charge. So you need to be mindful of this one-time large charge that you could hit— you get a hit on the income statement. With the balance sheet, the representation of depreciation is an accumulated depreciation, which is a contra asset account that sits right underneath the asset. So you have the asset as a positive value, and then you have a negative value for the accumulated depreciation. Net-net, that becomes your net asset value. Similarly, for intangibles, you have an accumulated amortization, which is a negative value that sits underneath the asset. Now, with the cash flow statement, we need to add these back in the cash from operating activity, right? So you have net income at the beginning of your cash flow statement, and then you add back these non-cash items. So the reason why we add them back is because these are non-cash in this period. The cash was spent a while ago when we either developed or purchased the asset. Right now there's no cash from it, it's only a non-cash depreciation amortization, and that's why we add it back to the section for cash from operations. Okay, so this is as far as the accounting concepts. Now let's jump into the insights that we get from this information. Okay, so what are the insights that you get as a CFO reading the financials when you look at depreciation and amortization? When you're looking at the income statement and you see high depreciation numbers, as a finance leader, the first thing you think about is the capital intensity that is needed for this business to operate. A high depreciation number tells me that this business requires a lot of capital spending to purchase assets to get the business to generate revenue, and that's why we have high depreciation. So you need to be thinking of what CapEx, uh, the business will need on an ongoing basis to operate and continue making money. The second thing is replacement. So a high depreciation on the income statement tells me that at some point I'm going to need to replace these machinery or factory buildings, whatever you have. The higher the depreciation, the higher I'm going to be thinking in terms of amount of money needed to replace these equipment or assets in the future. The third thing is maintenance. So the more I depreciate, the more it tells me that I have moving pieces in the business that I operate, and that tells me I will need to spend money on the maintenance of these items, which will hit the income statement in a period as an expense, but it also can be capitalized as a maintenance if it's going to enhance and make the life, the useful life of the asset longer, then it can be capitalized. but in most cases it gets expensed in a period. So this is in terms of high depreciation. So this is the kind of analysis that I think about when I am looking at the income statement for the depreciation numbers. One of the helpful KPIs that I use is fixed asset turnover, which is used to determine the efficiency of how we spend money on fixed assets and how we generate revenue from it, and is calculated by taking revenue divided by net PP&E, property, plant, and equipment, And if you're interested, I'm going to leave a link in the description of this video for a cheat sheet that includes the KPIs that you can get from the balance sheet with the calculation and the interpretation of these KPIs. Now, what about high amortization? When I see high amortization values on the income statement, I'm immediately thinking of whether this business is growing through merger and acquisition. So typically through merger with another company or an acquisition, you get the IP or intellectual property, patent, customer lists, brand value of this other their business. And typically when you see high amortization, that is a signal for M&A activity. Uh, with high amortization comes the risk for impairment. So this business has a bunch of intangible assets sitting on the balance sheet, and you need to be always measuring whether they continue to have the value and the number of useful years that you say they have. And at some point you sometimes have to take a one-time charge like how we described here the one-time charge for the income statement. Also, I think of the earning quality because when you look at net income for the business, it's going to have a bunch of amortization of a previous activity for the business that is impacting the current period earning quality. And because of that, a lot of financial analysts use EBITDA, earnings before interest, tax, depreciation, and amortization, to measure the true profitability of the business based on operating activity in this period and not based on capital structure decisions that were made in prior periods in acquiring or M&A activity for this business. So in summary, understanding these concepts here is what separates an accountant from a true finance leader, because an accountant knows how to mechanically operate these items here, while a true finance leader understands the implications on the three financial statements knows how to anticipate risk, and knows how to support the process of business decision for the company. I hope that you enjoyed this video, and I'll see you in the next one.