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.
|Estimated Useful life|
|15 years||7 years|
|Amortization calculated (SLM)||77||165|
|As a % Revenue|
|Amortization calculated (SLM)||3.3%||7.2%|
|Difference in Margins||3.9%|
|Operating Profit Margin||~76%||72%|
Amortization Policy of Company & Peers:
|Company/Peer||Asset||Estimated Useful Life|
|Indian Energy Exchange||Computer Software||6 & 15 Years|
|Indian Energy Exchange||Software Licenses||15 years|
|EPEX Spot (Power Exchange)||Software Developed Internally||3 to 5|
|Johannesburg Stock Exchange||Capitalized Development Costs||3 to 7 Years|
|Hong Kong Stock Exchange||Computer Software Systems||Up to 5 years|
|CME Group||Technology Related IP||4-5 Years|
|Intercontinental Exchange||Developed Technology||5 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.
(SEBI Registered Portfolio Manager – Registration No. INP000002965)
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