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Comment by scarface74 | Hacker News Reader

Not counting depreciation as part of your loss in a business is about like all of the Uber drivers who don’t take into account the wear and tear on their cars when calculating how much money they are making. Depreciation is a real expense. If you depreciate an asset down from $1000 to $0 in 3 years, you’re accounting for the fact that in three years you are going to have to replace it.

There is a reason we have GAAP, to keep crap like WeWork’s “Community Adjusted Ebitda” and Uber from saying that their financials really aren’t as bad as they look if you ignore a dozen expenses.

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Imagine you're a growing startup, and you have a yearly recurring investment (you're growing, after all!) of $1000 that's linearly depreciated over 5 years.

Let's say your income is 1100$ each year.

Your profit, according to accounting, would be 900$ for the first year, counting only $200 of the investment, then for the following years you'll see a profit of $700, $500, $300, and $100, as the investments accumulate. Oh no! A downward trend!

The cash flow, however, will simply show $100 profit each year.

Which one is more representative of the growing business with recurring investments?

That’s exactly the story that YC darling DropBox has been telling over the last decade. They still aren’t profitable and according to their own disclosures, have no idea when they will become profitable.

Just as as microcosm, how many YC backed companies have reached profitability? Only two have gone public - DropBox and PagerDuty.

I'm not sure that I understand your scenario. If you actually need to replace the equipment after 5 years, the accounting approach seems like the most valid approach.

For my understanding, do you mean that cash flow would show $100 profit each year on the 5th year, whereas in the first year it would show $900 profit? Thanks.

In year one, you’re generating $1100 of income with $1000 of capital invested (that will last 5 years).

By year five, you’re generating $1100 of income with $5000 of capital invested (that will require $1000 each year to keep up).

You’re _way_ better off in year one here, so it seems the GAAP approach is actually showing the decline accurately. This isn’t a growing startup, it’s a startup needing more equipment to make the same money each year.

You're right, growing capital but not growing income... I made a poor example.

(Imagining a bottom pricing scenario, while keeping a positive cashflow.)

Good point. At year 6 this logic breaks down. (Then again, no longer a 'startup' at that point.) Better hope the replacement equipment is double worth it's money. :)

Should make some spreadsheets with more scenarios.

Amusingly, assuming the example company's pricing remained the same throughout rather than cutting prices each year, the client base ends up fixed, the clients get 5x better service by the 5th year, while accounting shows a decline in performance.

External perception of business health (5x better service!) unintuitively is masking the the accounting reality here (worsening returns).

(Now look at all these cloud services giving better services and pricing every year, seemingly very healthy...) :)

The thing is that depreciation is not a cash expense, companies will push the depreciation to the highest reasonable amount to reduce the amount of tax on their profits.

A commonly used valuation technique (discounted cash flow or DCF) relies on projected free cash flows and adjusting for expected CAPEX.

Also there’s GAAP depreciation and tax depreciation, and firms will try and use different depreciation schedules between the two in order to create deferred tax liabilities which boost cash flow early on.

> If you depreciate an asset down from $1000 to $0 in 3 years, you’re accounting for the fact that in three years you are going to have to replace it.

but does a company have to be "honest" about such depreciations? What if the asset isn't actually losing value at the stated depreciation rate? Then at the end of the depreciation period, the company may still extract the residual value by either selling or continue using the asset. Does that somehow then count as revenue? Or did they just magically managed to tax dodge using a fake depreciation schedule?

The asset will eventually have to be replaced. In the long term, it doesn’t make a difference - ignoring the time value of money.

Theoretically, the only reason we have depreciation expenses at all instead of just expensing the entire cost at once (cash accounting) is that we decided that accrual accounting was more representative than cash based accounting.

I am not an accountant. I’m an MBA dropout after almost finishing.

Also, taxes. If we were able to fully expense capital plants and equipment, there wouldn't a single company paying taxes, they would continually purchase more to offset profit, eliminate taxation, and accelerate growth.

Is that a bad thing?

As far as governments are concerned, yes, as they will never get tax revenues from companies if they are allowed to fully expense large purchases.

Accounting was a decade ago for me, but as I recall if you sell an item you've depreciated to $0, you will incur a "Gain on Item Sold" which is taxable.

This might be different in various countries, but in general companies cannot play games with depreciation. The financial audit is done according to certain rules and common practices. In reality some of these investments might be hard to properly calculate and audit, but simply reporting them as zero is malicious. EBITDA numbers should provide the insight into profitability without hiding anything.

It's generally fine to mark down your assets faster than they actually become obsolete, so you can take all the depreciation in year 0 if you want. Marking them down slower and overstating profitability is not so cool.

There are rules in place which assets depreciate at which rate. Otherwise companies could just cheat their way through accounting.

On a cashflow basis, you incur 100% of the depreciation at the moment you pay for it.

But wouldn’t your profit be awesome the years you didn’t have to claim depreciation?

Hence you’ve invented EBITDA and EBITDA less capex :)

Damnit that was a major self own I just did wasn’t it?

It just means you’ve internalized the concepts!

I know about WeWorks deceptive accounting/reporting practices, but not sure what similar thing Uber has done when it comes to accounting?

https://investor.uber.com/news-events/news/press-release-det...

We define Adjusted EBITDA as net income (loss), excluding (i) income (loss) from discontinued operations, net of income taxes, (ii) net income (loss) attributable to non-controlling interests, net of tax (iii) provision for (benefit from) income taxes, (iv) income (loss) from equity method investment, net of tax, (v) interest expense, (vi) other income (expense), net, (vii) depreciation and amortization, (viii) stock-based compensation expense, (ix) certain legal, tax, and regulatory reserve changes and settlements, (x) asset impairment/loss on sale of assets, (xi) acquisition and financing related expenses, (xii) restructuring charges and (xiii) other items not indicative of our ongoing operating performance.

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