Depreciation, amortization, capex and leases

Key takeaways

• Depreciable cost is cost less salvage value; straight-line spreads it evenly, declining balance front-loads it, and units of production ties it to use.
• Every method expenses the same total over an asset's life; the method and the useful life estimate only change timing, which moves reported profit between years.
• Capitalizing a cost instead of expensing it raises EBITDA immediately and shifts the cash outflow from operating to investing activities.
• Maintenance capex keeps existing capacity running and is a recurring cost of the business even though EBITDA ignores it; growth capex is discretionary.
• US GAAP tests long-lived assets for impairment with an undiscounted cash flow screen first, while IFRS compares carrying amount directly with recoverable amount, so IFRS can recognize impairments earlier.
• IFRS 16 treats nearly every lease as depreciation plus interest, which removes rent from EBITDA; ASC 842 keeps a single straight-line lease cost for operating leases, which stays inside EBITDA.

Capitalize or expense

The first decision is whether a cost belongs on the balance sheet at all. A cost is capitalized when it creates or improves an asset that will benefit more than one period: buying equipment, constructing a building, and, under specific criteria, developing internal-use software. The capitalized amount includes everything needed to bring the asset to working condition, such as delivery, installation and testing, and, for assets built over a long period, interest incurred during construction.

A cost is expensed when its benefit is used up in the current period. Routine repairs and maintenance that restore an asset to its previous condition are expensed. Improvements that extend an asset's life, increase its capacity or improve its output are capitalized. The distinction is often a matter of judgment, and most companies also set a capitalization threshold below which items are simply expensed regardless of life.

The effect of the choice is larger than it looks. Capitalizing moves the cost out of operating expenses, so EBITDA rises by the full amount in the year of spending. It moves the cash outflow from operating activities to investing activities, so cash from operations rises too. Total profit over the asset's life is unchanged, but the path of EBITDA and operating cash flow, the two numbers most valuations and credit tests rely on, is not.

Straight-line depreciation, useful life and salvage value

Depreciation starts from depreciable cost: the capitalized cost of the asset less its salvage value (called residual value under IFRS), the amount the company expects to recover when it disposes of the asset at the end of its useful life. The useful life is the period over which the company expects to use the asset, which may be shorter than its physical life if the company replaces equipment early.

Straight-line depreciation charges the same amount every year. It is by far the most common method for financial reporting under both US GAAP and IFRS, because most assets deliver their benefit fairly evenly and the method is simple to audit. Land is not depreciated, because it does not wear out.

Both inputs are estimates, and both are levers. Lengthening a useful life from five to eight years cuts annual depreciation substantially and raises reported EBIT, with no change in the business. IFRS requires useful lives and residual values to be reviewed at least at each financial year end. US GAAP requires a change when events or circumstances indicate the estimate is no longer appropriate. Either way, a change is applied prospectively, spreading the remaining book value over the revised remaining life, not restating past years.

Declining balance and units of production

Accelerated methods charge more depreciation early in an asset's life and less later. The double declining balance method applies twice the straight-line rate to the opening net book value each year. Because it applies a percentage to a declining balance, it never reaches salvage value on its own, so the charge is capped in the year that would take book value below salvage. Many companies switch to straight-line for the remaining life once straight-line would give a higher charge. Accelerated methods suit assets that lose productivity or value quickly, such as technology equipment, and mirror the accelerated schedules many tax systems use.

Units of production ties depreciation to use rather than time. The company estimates the total output or hours the asset will deliver, computes a rate per unit, and charges depreciation for the units actually produced in each year. It suits assets whose wear depends on activity, such as mining equipment, aircraft engines measured in flight hours, or a press measured in cycles. In a slow year, depreciation falls, which makes margins less sensitive to volume than straight-line.

Whichever method is chosen, total depreciation over the asset's life is the same: cost less salvage value. The methods differ only in timing, so a change in method moves the profile of earnings, not their total.

Amortization of intangible assets

Amortization is the same allocation applied to intangible assets. Intangibles with a finite useful life, such as acquired customer relationships, patents, licenses and capitalized software, are amortized, almost always straight-line, over that life. Intangibles with an indefinite life, such as some trademarks, are not amortized but are tested for impairment at least annually.

Goodwill, the excess of an acquisition price over the fair value of the identifiable net assets acquired, is not amortized under IFRS or under US GAAP for public companies. It is tested for impairment instead. US GAAP gives private companies an accounting alternative that allows goodwill to be amortized, generally over ten years or less, which is one more reason to check the basis of preparation when reading private company accounts.

For acquisitive companies, amortization of acquired intangibles is often excluded from adjusted earnings as a cost of past deals. The counterargument is that customer relationships do decay, and replacing them costs real sales and marketing money.

Maintenance capex and growth capex

Capital expenditure has two economically different parts. Maintenance capex is the spending needed to keep the existing asset base producing at its current capacity: replacing worn equipment, refurbishing stores, refreshing IT hardware. Growth capex is spending that expands capacity or enters new activities: a new plant, new stores, a new product line. Maintenance capex is effectively a recurring operating cost that happens to be capitalized. Growth capex is an investment decision the company could defer.

Companies are not required to disclose the split, so analysts estimate it. Common approaches are management's own disclosure where given, the capex of a period with no capacity growth, a bottom-up count of assets due for replacement, or depreciation as a rough proxy. The depreciation proxy is weak when the asset base is growing, when asset prices have risen since the assets were bought, or when useful life estimates are unrealistic.

The split matters because a buyer valuing a company on EBITDA is implicitly assuming the cash needed to sustain that EBITDA is small. Subtracting maintenance capex tests that assumption.

Impairment basics

Depreciation assumes an asset delivers its benefit as planned. When circumstances change, such as a plant becoming idle, a product line losing customers or a sharp fall in market prices, the asset may be worth less than its book value. An impairment writes the carrying amount down to reflect that loss. It is a non-cash charge, excluded from EBITDA, and it lowers future depreciation because the asset base is smaller.

The two frameworks test long-lived assets differently. Under US GAAP, an asset group held and used is first tested for recoverability: if the undiscounted future cash flows it is expected to generate exceed its carrying amount, there is no impairment, however low its fair value. Only if that screen fails is the asset written down to fair value. Under IFRS, set out in IAS 36, there is one step: the carrying amount is compared with the recoverable amount, which is the higher of fair value less costs of disposal and value in use (the present value of expected cash flows). Because IFRS uses discounted figures directly, it tends to recognize impairments earlier.

Reversals also differ. US GAAP prohibits reversing an impairment of an asset held and used. IFRS requires a reversal, other than for goodwill, when the recoverable amount recovers, capped at the book value the asset would have had without the impairment.

Leases under IFRS 16 and ASC 842

A lease is a contract that conveys the right to control the use of an identified asset for a period in exchange for payments. Under both IFRS 16 and ASC 842, the lessee (the user of the asset) recognizes two items at the start of almost every lease: a lease liability, equal to the present value of the lease payments not yet paid, and a right-of-use (ROU) asset, equal to the lease liability plus any payments made before commencement, initial direct costs and restoration obligations, less incentives received. Payments are discounted at the rate implicit in the lease if it can be determined, which for a lessee it usually cannot, and otherwise at the lessee's incremental borrowing rate.

Both standards exempt short-term leases of twelve months or less. IFRS 16 adds an exemption for leases of low-value assets, such as laptops, which ASC 842 does not have. On initial measurement, the two standards produce the same balance sheet.

The difference is in what happens next. IFRS 16 has a single lessee model: every recognized lease is accounted for like a financed asset purchase. The ROU asset is depreciated, usually straight-line, and interest accrues on the liability using the effective interest method. Total expense is front-loaded, because interest is highest when the liability is largest.

ASC 842 keeps two lessee models. A lease that meets any of the finance lease criteria (ownership transfers, a purchase option the lessee is reasonably certain to exercise, a term covering a major part of the asset's economic life, payments amounting to substantially all of its fair value, or an asset so specialized it has no alternative use to the lessor) is a finance lease, accounted for like IFRS 16. Every other lease is an operating lease: the company still carries the ROU asset and the liability, but recognizes a single lease cost, usually straight-line, inside operating expenses.

One lease under both standards

Harlow Retail, a hypothetical chain, signs a five-year lease for a store. It pays $1.0m at the end of each year, has no initial direct costs or incentives, and its incremental borrowing rate is 6 percent. Before any lease cost, the business earns EBITDA of $20.0m. The lease does not meet any ASC 842 finance lease criteria, so a US GAAP reporter treats it as an operating lease. Figures are in $m, rounded to three decimals.

The key result is that the lease liability is identical under both standards at every date, because it is the same present value unwinding at the same rate. What differs is where the cost appears. Under IFRS 16, EBITDA is $1.0m higher, but EBIT and pretax income carry depreciation and interest, and in Year 1 the total charge exceeds the cash rent. Under ASC 842, EBITDA absorbs the full $1.0m, while pretax income is slightly higher in the early years and lower in the later ones. Over five years, total expense is $5.0m under both.