While GAAP accounting rules are strictly uniform when it comes to consolidated financial statements, other features that can materially affect those consolidated results, like computer software depreciation, are more arbitrary.
However, this isn’t necessarily a bad thing. Not all assets are the exact same, and many have different utility and length of usefulness (or useful life).
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So, computer software depreciation fits in with other types of discretionary GAAP determinations, as another consideration in Plant, Property, and Equipment (PPE) accounting.
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- What is Asset Depreciation?
- When to Use Depreciation
- The Depreciation of Computer Software
- Is Software an Intangible Asset?
- Average Computer Software Depreciation Schedule of the S&P 500
This is a jam packed post, particularly if you’re not well versed in basic accounting concepts like depreciation. I started with the basics which can provide a quick refresher, and added some important peculiarities around software that you won’t find with other assets.
Let’s dig in.
What is Asset Depreciation – The Basics
Depreciation, in its most simplest explanation, is the spreading out of the cost of a big expense for a business.
You may also hear the word depreciation incorporated with amortization, which is essentially the same thing as depreciation but for intangible assets.
The deprecation of an asset does two things:
- Represents the (real) depreciation (or loss) in value of an asset over time
- Gives a more consistent representation of a company’s financials from year to year
Assets can lose value over time for a variety of reasons.
A more traditional physical asset, such as a piece of equipment or machinery used to manufacture products, breaks down over time as its parts get old—and must eventually be replaced.
Even a non-physical, or intangible asset, can lose value over time—a brand may become less popular with younger consumers, or a proprietary technology may lose value as emerging tech takes its place.
As such, companies need to reflect this reality in their financials, and so they depreciate the asset on the balance sheet over time. This reduces its value on the balance sheet as years goes on.
Remember all accounting must reconcile, and so changes in the balance sheet need to be reflected in other financial statements. To reconcile this particular loss in value, the company takes a depreciation expense on its income statement.
The depreciation charge reduces Net Income for that year, as it is an expense.
Eventually, as the asset’s value approaches zero, the asset reaches the end of its useful life and no longer accrues depreciation charges.
Depreciation Utility #2 – Improved Representation of Company Financials
An additional benefit of the inclusion of depreciation in GAAP accounting is that it also provides a more consistent representation of a company’s earnings and profitability performance from year to year.
Which also provides useful to the IRS for fair tax policies as well…
Say that a company wanted to expand its bubble gum producing capabilities for its wildly popular new branded gum. So, they spend all of this year’s earnings on 3 new machines to increase output by 25%.
If there was no depreciation on this investment, the company would report $0 in Net Income for the year, because the money was all reinvested.
However, that doesn’t reflect the reality of the business. The company actually did earn a profit this year, and even though they are sacrificing the benefits of those profits now (say, with a dividend) to grow the business with their large asset purchase, they were still profitable.
If the company did the same thing again in 3 more years, and if there wasn’t any sort of accounting rule such as depreciation, well then the company would report very lopsided earnings—reporting huge profits in the years that no capital investments were made, and then reporting little or no (or even negative) earnings in the years they heavily reinvested in the business.
That’s why depreciation is a GAAP standard, and becomes helpful in understanding the long term profitability of a company from year to year.
When to Use Depreciation
To determine whether a cash outlay is charged as an expense to the income statement or as an investment in a long term asset that carries a depreciation expense over time, management needs to estimate whether that cash outlay will likely result in steady cash flows for the long term or has more impact in the current year.
But, there’s also considerations depending on the kind of cash outlay that is made which determines whether it becomes depreciated or not.
I often hear the argument that early stage growth companies are unprofitable because they are reinvesting everything back into the business.
But not all expenses are equal, just as not all assets (and their depreciation) are equal.
Take two major examples of this (capital spending that is not depreciated):
- Sales expenses
- R&D expenses
Sales expenses are part of Selling, General, and Administration (SG&A) expenses on the Income Statement. An early growth stage company may choose to heavily reinvest revenues into sales personnel in order to take as much market share as possible. This would likely create long term cash flows as a company establishes a dominant market position, however it is an expense that is not allowed to be depreciated, even if it’s a heavy reinvestment by the company.
In a similar vein, a company that is spending mightily to upend current market players by introducing innovative technology through R&D investments also isn’t allowed to depreciate these expenses over time, even though just one new invention could stimulate company cash flows permanently.
However, both of these expenses/ investments, while long term in nature—aren’t guarantees for future cash flows. Investments in fixed (PPE) assets don’t represent guarantees of future cash flows either, and can sometimes be charged as future impairments if new determinations estimate less cash flows.
But, it seems that R&D and marketing expenses are much less reliable indicators of future cash flows, and can have much higher potential of waste, as efforts for new creation can be in vain.
Also key to note is that R&D and SG&A expenses can include expenses on people/staff, while expenses on fixed assets generally do not.
The Depreciation of Computer Software
There’s many types of assets that get depreciated over the years, and they can be defined either as a long term fixed asset such as Plant, Property, and Equipment, or as an intangible asset / Goodwill.
These can include assets such as:
- Plant, Property, Equipment
- Land
- Buildings
- Machinery and Equipment
- Software
- Information Technology Assets
- Intangible Assets
- Brand power
- Intellectual property
- Patents
The accounting for intangible assets and goodwill is a little tricky as it relates to acquisitions, and its treatment for depreciation (amortization) is different than for fixed assets.
However, in the case of computer software, most companies report that as part of their fixed Plant, Property, and Equipment assets (as of today, in the year 2020).
Because software nowadays has become an integral part of business, it’s now included as a fixed asset on most company’s balance sheets (at least, of those top companies in the S&P 500).
As such, software that qualifies as PPE would be depreciated like any other fixed asset, on its own schedule. That means that depreciation expenses on the income statement would be spread out over the determined useful life of the software, rather than being expensed all upfront.
Caveat: R&D Software Is NOT Depreciated
Interestingly, if software is purchased for R&D it is not allowed to be depreciated, since R&D expenses aren’t depreciated either. However, if the software can be proved to have other uses outside of R&D, then it can placed as a fixed asset and depreciated like previously discussed.
Acquisitions throw another wrench into the R&D capitalization conversation if a product was in the middle of being developed (In-Process R&D Expenses), but in general it’s good to know this important distinction between R&D software and “long term asset” software.
Is Software an Intangible Asset?
Notice all of the ambiguity through this article.
That really encompasses the reality of software depreciation.
Since there’s always been wiggle room around the deprecation of assets in general and their depreciation schedules, software falls into this category—and then some.
It seems that software can be a fixed asset or an intangible asset depending on its features. For example, if a computer software is an integral part of hardware that would be classified as PPE, then that software would also be depreciated along with the physical hardware and also classified as PPE.
If a software is “stand alone’, it could instead be classified as an intangible asset.
Then you have the differences between if the software is developed in-house or if it is purchased or licensed…
But in general, management has the discretion to make these decisions on whether to capitalize (depreciate) their software or not, and for how long.
As investors/ analysts, it’s not so much about questioning that decision making per se.
However, knowing when a computer software depreciation schedule looks way out of the ordinary or if it is an obviously significant part of the business not being accounted for (or vice versa), then further digging would be in order—and you’d only know to do that by understanding the nuts and bolts of software depreciation and also have context on general standards around that depreciation.
Though there’s little to be gleaned from a sort of GAAP requirement, a broad observation on some of the biggest companies and their policies can provide a good starting point for evaluating computer software depreciation.
Average Software Depreciation Schedule (S&P 500)
Because there’s no GAAP standard for software depreciation, there’s also little in the way of clean datasets to filter metrics such as “useful life” or tangible vs intangible asset classification. It’s not as simple as finding any number of GAAP metrics that can be quickly sorted with a free stock screener.
Because of this, to find the average software depreciation that would best represent the S&P 500, I made the following observations and decisions.
As of the market open on 9/2/20:
- Total S&P 500 market capitalization = $32.3T
- Top 7 stocks S&P500 market cap = $8.2T
- Top 14 stocks S&P500 market cap = $11.2T
- Top 21 stocks S&P500 market cap = $12.9T
You can see that there’s diminishing returns on including more stocks in the sample size. In other words, including 7 more stocks (from 14 to 21) only increases the percentage of the S&P 500 examined by about 15%.
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I felt the good balance point between sifting through many current 10-k’s and getting more representation of the S&P 500 fell right at 14 stocks.
Amazingly, only 14 stocks right now represent 35% of the total S&P 500, and many of these are some of the biggest technology names that heavily incorporate software into their business models already (Apple, Microsoft, Google, Facebook, etc).
Sifting through these 10-k’s, I inspected each company’s general policy around computer software depreciation and included them in the table below.
Note: Not every company in the list reported anything about either software as an asset, or software useful life (for depreciation). Berkshire Hathaway (BRK-B) and Walmart (WMT) did not include this information in their most recent 10-k’s.
Investor Takeaway
GAAP accounting can get confusing when you go past the general metrics and dive into the specifics. But much of the mystery and ambiguities can be found right inside the Notes to the Financial Statements, which really emphasizes their importance.
When it comes to computer software depreciation, it seems like the business world is becoming more and more digitized every single day.
And with these encompassing greater portions of business models, the accounting rules around software will become that much more critical in evaluating the fundamentals.
Like with many other key details of reading a company 10-k, understanding software depreciation is one of those things that’s important when it’s important.
Meaning, applying your knowledge about the topic won’t make a difference most of the time. But when it does come time to either spot irregularities, or evaluate real earnings power on large depreciation charges, the information here can be priceless.
Or, you could even say, intangible.
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