Lesson 3 of 8
Costs that moved
A depreciation life is an estimate management sets, and a supplier discount has a period it belongs to. Two settled orders show what moving either one does.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Depreciation depends on an estimated useful life, so extending that life moves cost out of this year into later ones without any transaction taking place.
- In a settled order dated 31 December 2018, the Commission found that Hertz extended the planned holding periods of a large part of its US car rental fleet in 2013 and did not adequately disclose it.
- In a settled order dated 3 September 2021, the Commission found that Kraft Heinz recognised supplier savings early, and that cost of goods sold across the period would otherwise have been about 50 million dollars higher.
Costs have two dials. One is the period a cost lands in, which depreciation schedules and accrual estimates control. The other is whether a cost appears on the income statement at all this year, which capitalisation controls. Neither dial needs a transaction to move.
Two dials, two settled orders
| Dial | The case | What the order describes |
|---|---|---|
| The estimated life inside depreciation | Hertz, order dated 31 December 2018 | A 2013 decision to extend planned holding periods for a significant portion of the US car rental fleet, one of the variables in the depreciation formula, without adequate disclosure of the decision or its effects |
| The period an expense saving belongs to | Kraft Heinz, order dated 3 September 2021 | Supplier agreements documented as though savings were for past or same-year events when they were payments for future commitments, so the savings were recognised early |
Why a useful life is a lever
Depreciation is a purchase price spread over an estimated life. The estimate belongs to management, it is revised when management's expectations change, and a revision is applied going forward rather than by restating the past.
Extend the life and this year's charge falls, profit rises, and nothing has happened in the world. The revision may be entirely correct: if the assets really will be held longer, the old schedule was wrong. What a reader needs is to be told, because the change is not visible in the depreciation line itself.
The Hertz order describes a 2013 decision to extend the planned holding periods of a significant portion of the US car rental fleet. The order states that the planned holding periods were one of the variables in the formula used to depreciate the rental assets, and that the decision and its effects on the business, including maintenance costs, were not adequately disclosed to investors.
Why a supplier discount has a period
If a supplier pays cash upfront or grants a discount in exchange for something the buyer will do later, the saving belongs to the period in which the buyer performs. Booking it now pulls future profit into this year.
The Kraft Heinz order describes procurement staff negotiating and maintaining supplier contracts documented as though savings were given for past or same-year events, when they were payments for a future benefit. The order states that approximately 59 transactions were improperly recognised over the period from the fourth quarter of 2015 to the end of 2018, and that with correct documentation and accounting the company's cost of goods sold over that period would have been approximately 50 million dollars higher.
Both companies consented to the orders without admitting or denying the findings.
Where to look
For the depreciation dial: the significant accounting policies note gives useful lives by asset class, and comparing this year's ranges with last year's catches a revision. A change in estimate is also required to be disclosed when material.
For the expense-timing dial: supplier rebates and vendor allowances sit in the revenue or cost-of-sales policy note, and a rising balance of prepaid or receivable amounts from suppliers is the balance-sheet trace of a saving recognised before it was earned.
Check yourself
Why is an estimated useful life a lever on reported profit?
- Because it changes the cash paid for the asset
- Because it sets the annual depreciation charge, and a revision is applied going forward without any transaction occurring
- Because it changes the asset's tax basis
Show the answer
Answer: B.
Depreciation spreads a fixed purchase price over an estimated life. Change the estimate and this year's charge changes, with no cash, sale or purchase involved.What did the Kraft Heinz order say the cost of goods sold would have been across the relevant period, had the transactions been documented and accounted for properly?
- Unchanged
- Approximately 50 million dollars higher
- Approximately 208 million dollars lower
Show the answer
Answer: B.
The order states approximately 50 million dollars higher across the period from the fourth quarter of 2015 to the end of 2018, arising from about 59 transactions.Which disclosure catches a change in depreciation life?
- The auditor's report
- The significant accounting policies note, where useful lives by asset class can be compared with last year's
- The proxy statement
Show the answer
Answer: B.
Useful lives are disclosed by asset class in the policies note, and a material change in estimate has its own disclosure requirement.Sources
- SEC, In the Matter of Hertz Global Holdings, Inc. and The Hertz Corporation, Securities Act Release No. 10601, Exchange Act Release No. 84979, Accounting and Auditing Enforcement Release No. 4012, 31 December 2018. Settled without admitting or denying the findings.
- SEC, In the Matter of The Kraft Heinz Company and Eduardo Pelleissone, Securities Act Release No. 10977, Exchange Act Release No. 92874, Accounting and Auditing Enforcement Release No. 4248, 3 September 2021. Settled without admitting or denying the findings.
- ASC 360, Property, Plant, and Equipment, for the depreciation of long-lived assets over their estimated useful lives.
What this leaves out
- Both matters were settled and the respondents consented without admitting or denying the findings, which are not binding on any other person or entity.
- Every statement here is confined to what the two orders say. Neither company's later conduct is described, and nothing here is said about any company not named in an action.
- Extending a useful life is frequently correct and is not itself evidence of anything. What the Hertz order concerns is the adequacy of the disclosure around a specific 2013 decision.
- The worked example uses invented round numbers and is labelled illustrative.
- Nothing here is advice about any security.