> From Doug:
>
> If software were depreciated rather than expensed, reported
> earnings would be higher.
>
> Only today; tomorrow, they would be lower. In the long-term, it's
> the same. You can't depreciate what you didn't pay for -- despite
> this wacky idea of "capitalizing new ideas" ... can you imagine
> getting a deduction (depreciation is a current expense, and thus
> deductible) for something you didn't pay for? Sure, you paid the
> person who had the idea -- but payroll already is an expense.
>
> Maybe an example is useful. Say you have a company that buys $9k
> of software in year 1 and has $2k of revenue the first year,
> increasing by $2k per year over three years: $4k the second year,
> $6k the third. $12k total. If software is expensed immediately,
> you have "profits" that look like this:
>
> Year 1: ($2k - $9k = -$7k)
> Year 2: ($4k - $7k loss carry-forward = -$3k)
> Year 3: ($6k - $3k loss carry-forward = $3k)
>
> In that third year, you show a $3k profit and pay tax on it. If
> your accounting period were three years long instead of one year,
> you'd have one big "year" that looked like ($12k - $9k = $3k).
>
> I.e., it's the same.
>
> On the other hand, if you depreciate it over three years, you have
> books that look like this:
>
> Year 1: ($2k - $3k = -$1k)
> Year 2: ($4k - $3k - $1k loss carry-forward = $0k) [you just broke even!]
> Year 3: ($6k - $3k = $3k)
>
> These numbers are contrived to give the exact same answer in both
> cases, but it's easy to see how capitalization vs. expense is just
> a question of how long your reporting period is. In the real world,
> capitalization does nothing but raise tax revenues. Since it takes
> longer to write it down than it did to spend it, you show profits
> in the interim that get taxed sooner than you're done writing it
> off -- of course those taxes are deductible against future earnings,
> so you'll eventually "get it back" (in the form of additional
> expenses incurred in future accounting periods, which of course
> depresses earnings) but you get it back more slowly than you gave
> it to the government.
This is true only for a single asset. When you look at a firm with multiple assets, which buys new equipment each year, both to replace stuff that is worn out (fully depreciated) and to add to capacity as sales grow, Doug's original conclusion holds. Expensing assets understates profits compared to depreciating them. Effectively, you never get to "tomorrow" on the multi-asset firm's books. The value of the expensing will, under normal circumstance, always exceed the value of the depreciation.
This effect is exacerbated as prices rise--expensing all of the higher priced asset in the year it's bought vs. adding part of its cost to the undepreciated, original cost balance. But what if asset prices drop? This would work in the opposite direction, to counteract the conclusion.
Roger