LONDON -- Last Tuesday I wrote about how accounting rules make it all but impossible for companies to value brands in their accounts. Today I'll explain how companies take advantage of these rules to boost their reported profits.
Over time, a company's buildings and machines will gradually wear out. This is allowed for in the accounts by making a charge for depreciation, which is based upon the value of the assets and their expected working lifetime. This is set against both the assets and profits.
However, if you look at some companies' accounts, you'll see that the depreciation charge used is lower than that required by the taxman for calculating their tax liabilities. Companies do this because a lower depreciation charge means higher reported profits.
We don't do depreciation
Property companies generally don't depreciate their freehold properties. The reason for doing this -- one which I totally agree with -- is that their expenditure for maintenance and repairs should be sufficient to offset the depreciation. However, if they don't spend enough, then they should make a depreciation charge.
But when they calculate their corporation tax liability, the properties are depreciated at the maximum rate allowed by the taxman, because this reduces what they have to pay in tax.
More than 500 million pounds in profit and a tax rebate
You'll see a good example of this in the 2012 annual report of Britain's largest property company, Land Securities
Had it depreciated its buildings over a 50-year period, which is common practice, this would have created a 145 million pound depreciation charge against its profits. Land Securities did, however, claim enough allowances to reduce its effective corporation tax rate for 2012 to about -1.5%. So on 515.7 million pounds in profit, it received a tax rebate of 8 million pounds.
Similarly, British Land reported just 1 million pounds of depreciation on almost 4.8 billion pounds of properties in its most recent results, while the central London office specialist Great Portland Estates didn't report any depreciation.
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Watch out for obsolescence
Most companies will depreciate their freehold properties over periods of 10 to fifty years. But if technological and/or social change impairs the value of these properties or of the companies' other assets, then the depreciation rates used will probably be insufficient to allow for the reduction in the value of their assets.
This happened to a lot of canals in the 1830s as soon as a railway was built to follow a similar route. Canals that were valued at millions in the books turned out to be worth very little, because rail freight took away most of their business within a few years.
But if a 21st-century equivalent of Nikola Tesla invented a cheap way to wirelessly broadcast huge amounts of electricity over long distances, National Grid would be left with a greatly overvalued asset on its books.
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Tony owns shares in Great Portland Estates and National Grid. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.