Taking Management Estimates with a Pinch of Salt

Quality of Earnings
Though much of the financial statement reporting is governed by prevailing accounting standards, the management of a company has certain leeway in terms of making certain assumptions and discretion’s, which does have a bearing on reported fundamentals.

One such management discretion or estimation is with respect to the useful life of an asset which would have a bearing on Depreciation & Amortization expense reported in the income statement, and can thus impact the reported profits.

To illustrate the point further, we present a case which we came across while working on the power exchange sector in India.

This leading power exchange company had purchased a perpetual software license that it is amortizing over the estimated useful life of 15 years. The company has reported in its accounting policy that the estimated useful life of the computer software is 6 years or 15 years for different assets in that category, whereas the estimated useful life for software licenses is 15 years! When we compared with global peers, the average estimated useful life considered by them was between 3 to 8 years.

By using the estimated useful life of 15 years instead of 3-8 years as generally practiced by global peers, company might be following an aggressive amortization policy. This leads to reported profits being higher than it would’ve been, had it followed the amortization policy in line with its peers. Our calculations and assumptions suggest that the reported Operating Profit Margin was inflated by nearly 4% due to the management’s estimation of useful life of license being 15 years in contrast to general industry practice of 3-8 years, as shown below (a comparison of 15 years and 7 years as useful life of license). The Absolute Operating Profit is inflated by 5% due to the same.

Particulars(INR Mn.)
Estimated Useful life
15 years7 years
Revenue2,3042,304
Amortization calculated (SLM)77165
As a % Revenue
Amortization calculated (SLM)3.3%7.2%
Difference  in Margins3.9%
Operating Profit Margin~76%72%


Amortization Policy of Company & Peers:

Company/PeerAssetEstimated Useful Life
Indian Energy ExchangeComputer Software6 & 15 Years
Indian Energy ExchangeSoftware Licenses15 years
EPEX Spot (Power Exchange)Software Developed Internally3 to 5
Johannesburg Stock ExchangeCapitalized Development Costs3 to 7 Years
Hong Kong Stock ExchangeComputer Software SystemsUp to 5 years
CME GroupTechnology Related IP4-5 Years
Intercontinental ExchangeDeveloped Technology5 to 8 years

(Source: Company Annual Reports, Multi-Act Assumptions)

Technically and legally, the management is well within its rights to estimate the useful life of assets based on its wisdom and understanding. However as investors, we should be wary of such cases where different accounting assumptions can lead to a cognizable difference in reported earnings and true economic earnings of a business.

Global comparison of margins of such businesses and peers should be considered, keeping such accounting anomalies in mind.

Statutory Details: Multi-Act Equity Consultancy Private Limited
(SEBI Registered Portfolio Manager – Registration No. INP000002965)
Disclaimer
The views expressed in this article are for educational and reading purpose only. Multi-Act Equity Consultancy Private Limited (MAECL) does not solicit any course of action based on these views and the reader is advised to exercise independent judgment and act upon the same based on its/his/her sole discretion, their own investigations and risk-reward preferences.The article is prepared on the basis of publicly available information, internally developed data and from sources believed to be reliable. Due care has been taken to ensure that the facts are accurate and the views are fair.MAECL, its associates or any of their respective directors, employees, affiliates or representatives do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such views and consequently are not liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way for decisions taken based on the said article.It is stated that, as permitted by SEBI Regulations and the Company’s Employee Dealing Policy, the associates, employees, affiliates of MAECL may have interests in securities referred to in the information.The contents herein – information or views – do not amount to distribution, guidelines, an offer or solicitation of any offer to buy or sell any securities or financial instruments, directly or indirectly, in the United States of America (US), in Canada, in jurisdictions where such distribution or offer is not authorized and in FATF non-compliant jurisdiction and are particularly not for US persons (being persons resident in the US, corporations, partnerships or other entities created or organized in or under the laws of the US or any person falling within the definition of the term “US person” under Regulation S promulgated under the US Securities Act of 1933, as amended) and persons of Canada.
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b. Past performance of MAECL does not indicate its future performance.
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Portfolio Management Services (SEBI Registration No. INP000002965) are offered through Multi-Act Equity Consultancy Private Limited (CIN: U67120PN1993PTC074692), which is a wholly-owned subsidiary of Multi-Act Trade and Investments Private Limited; Investment Advisory Services (SEBI Registration No. INA000008589) are offered through Multi-Act Trade and Investments Private Limited (CIN: U65920MH1997PTC109513).