Security Analysis Chapter 34 The Relation of Depreciation and Similar Charges to Earning Power

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Security Analysis Chapter 34 (The Relation of Depreciation and Similar Charges to Earning Power) Notes as presented to the Vancouver Security Analysis Book Study Group
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  Chapter 34: The Relation of Depreciation and Similar Charges to EarningPower SummaryA critical analysis ofan income account must pay particular attention to the amounts deductedfor depreciation and kindred charges.Detailed Summary- Accounting theory governing depreciation charges:If a capital asset has a limited life, provision must be made to write off the cost of that asset bycharges against earnings distributed over the period of its life.- The analyst should ask three questions with respect to the depreciation feature of an incomeaccount: 1. Have the amortization charges been deducted from the earnings as here reported. 2. Are the rates employed reasonable, as judged by standard accounting practice? 3. Does the cost or lease to which these rates are applied reflect reasonably well the fair value of these assets to the investor?- Another misleading practice: A fairly careful investor will know enough to reject an earningsstatement in which it is announced that no allowance for depreciation has been made. But wherethe figures are given after depreciation he is not likely to make further inquiry on this point, sothat an understatement of these charges may do more real damage than their complete andadmitted exclusion.- Double accounting policies on depreciation: This is an issue of overshadowing importance inthe accounting practices of public utility systems.  American Water Work & Electric Company then year convertible 5% bonds in Feb. 1934 arecited as an example, which disclosed that the company had regularly been employing twodifferent bases for calculating property amortization charges. 1. For income tax purposes 2. At a much lower rate, in its reports to security holdersIf the company's own figures are used then its income tax rate would need to be adjusted.- Suggested Approach:Leasehold & Leasehold improvements: If a company has paid money for a leasehold, the cost isregarded as a capital investment that should be written off during the life of the lease.Additionally, if any structural improvements or fixtures installed, their cost must be writtendown to nothing during the life of the lease, since they belong to the landlord when the leaseexpires.Amortization of Patents: A patent should be dealt with in exactly the same way as a mining property i.e. its cost to the investor should be written off against earnings during its remaininglife.Amortization of Goodwill: Since goodwill has no duration of life apart from that of the businessas a whole, the analyst should adjust the earnings by cancelling the charge.Quotes The safety of senior securities or the attractiveness of a common stock should not be considered as established unless the question of the adequacy of the amortization charges has been raised and answered in the affirmative.    pg. 404 There is no convincing excuse for failure to state the amount of the depreciation charge, if no satisfactory indications on this point are available, the conservatively minded should resolve anydoubt against the company.    Questions1. Is the American Water Work & Electric Company example still relevant? Do some publicutility companies still calculate depreciation charges in this manner?
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