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Exclude Depreciation from Internal P&L Reporting?

I prepare an internal version of the P&L for the CEO and all of my division managers. My CEO wants his managers to "get real" about their results, but he doesn't want to see depreciation on the P&L. To him, it's not a "real number" because "...it's not cash". I'm fighting him a bit on this as my belief is that expense associated with the "using up" of the life of a hard asset should be on the P&L, the same way as the consumption of supplies and materials. I explained to him that the payment to buy those assets was indeed cash that never shows up on the P&L (capitalized). An example that I gave was, we just replaced a 30K obsolete server. I told him "that server is used up", and none of the division managers P&L's ever reflected the expense associated with that". I think he gets it, but he just can't handle how it makes it a bit harder to reach his target profit numbers. I'm curious if anyone else has fought this battle with their CEO or management team, and whether I should just "give up the fight". Thanks.

Answers

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Your problem is NOT depreciation and you already identified it...."he just can't handle how it makes it a bit harder to reach his target profit numbers.". If you were hitting and exceeding your targets, depreciation won't even be a conversation. I have been fortunate to have CEOs knowledgeable on financials and GAAP. Stick to your guns!

Topic Expert
Regis Quirin
Title: Director of Finance
Company: Gibney Anthony & Flaherty LLP
LinkedIn Profile
(Director of Finance, Gibney Anthony & Flaherty LLP) |

I agree with your CEO. If I am trying to turnaround an organization or trying to focus the business on real increases in revenues and expenses, that impact cash flow monthly, I want to exclude all those non-cash items that can distort. I want my line managers studying the p&l and understanding how their actions impact the bottom line. Managers become very frustrated when they are working very hard to bring about a change, yet they never seem to be able to get ahead as their individual p&l’s include things such as depreciation (maybe related to a purchase prior to their arrival) or management allocation.

I had a similar problem with a medium sized business I was assisting. They were very proud of their ability to keep headcount low, as evidenced by the p&l. The problem was that the personnel costs were artificially low as individuals came off the p&l when they changed from employees to owners. As you know, owners are paid off the balance sheet. In response I created a proforma income statement that included a line for personnel expenses (K-1). The cash flow drain became very clear.

So the real question to ask the CEO. “What is your reason for excluding the item?” There are very good reasons to show more than one view of the information – Standard P&L and Modified P&L. But, do not substitute the modified for the GAAP. Show both.

Good luck.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

People forget what a managerial set of books is all about... And it doesn't need to be GAAP compliant.

It needs to serve the needs of management.

Chris Shumate
Title: Accounting Manager
Company: Dominion Development Group, LLC
LinkedIn Profile
(Accounting Manager, Dominion Development Group, LLC) |

On the financials that I provide to management, banks, and owners, we have a Net Operating Income (Loss) which excludes things like depreciation and amortization because they do not have anything to do with the operating aspect of revenue. Then we have a line below NOI for Net Income (Loss). No one really looks at those amounts except the external CPAs, my boss, and me. NOI should be what the CEO is most concerned about. That's my opinion. Perhaps you need to separate the financials like this.

Prashant Narasimha
Title: Finance Manager
Company: MMI Llc
(Finance Manager, MMI Llc) |

I agree with Emerson, "stick to your guns". To meet your CEOs requirement you could perhaps show EBD (Earnings before Depreciation) as an additional measure at the bottom of your GAAP compliant P&L.

This way your P&L format remains intact and also shows information relevant to management decision making.

Ben Williams
Title: CFO
Company: Weiler Corp
(CFO, Weiler Corp) |

I agree with your CEO. He is trying to focus the business on generating cash. Managing cash generation (as can be reflected in a management P&L) is a different process than managing Capex. Depreciation is not real cash (except for the tax savings it may generate); it is an accounting fiction!

I also agree with the other posts that have identified a few different ways to do this. I personally like to see an EBITDA metric at the bottom of the P&L.

lorenzo de ferrari
Title: founder
Company: De Ferrari Finance Projects
(founder, De Ferrari Finance Projects) |

Both ways can be justified, and both are actually in use. You can use EBITDA, or EBITA, therefore including or excluding depreciation.
What is best depends on what the situation is, and the purpose of the reporting. For instance, if you are comparing the profitability of different product lines, where one product line owns many assets, while the other rents most of them, you should include depreciation, otherwise the asset-intensive product line gets an unfair advantage. The same applies if you are comparing different Regions, or different subsidiaries.
And of course, if you are measuring against a budget, you want to be consistent in criteria with how the budget was built.
Another thing to consider is whether the people measured have a say in the investment policy: for instance, if you use EBITA, and include depreciation, a manager can improve his EBITA by postponing investments. If this is within his powers, use EBITA, otherwise, better leave depreciation out.

Anonymous
(Financial Reporting Manager) |

We use EBITDA for our internal metrics and reporting, the idea being we want only those items under the control of the business unit managers to appear on the financials for which they are responsible.

Anonymous
(CFO) |

Thanks for the feedback. I think a good compromise is to pull the deprecation number OUT of the Operating Income section and place it in the Net Income section. Hence, both views are represented. That said, I do take some issue with the statements "...I want my line managers studying the p&l and understanding how their actions impact the bottom line.", and "...we want only those items under the control of the business unit managers to appear on the financials for which they are responsible." Realize that often times, it is the business unit managers who lobby for the purchase of expensive operating assets used by their units. These assets cost money, they increase the cost of operating their units, and the "using up" of those assets over time is an expense and "cost of doing business" to their units, which I think should be reflected in their operating results. Also consider the following example: Business unit A leases their mfg equipment, Unit B buys it's mfg equipment. B will have an inherent relative reporting distortion/advantage if no depreciation is reported. We've also had some debates of what constitutes "Cost of Sales", and these discussions get even more complicated when managers want to compare their results to "industry averages". The challenge then becomes, "what is industry norm in the treatment of COS or Depreciation" (don't respond to that, I know it's a crapshoot!). Thanks again for the feedback. I love this forum.

Anonymous
(Director of Finance) |

For our internally distributed financials that go to the various levels of managers, we do a breakout of expenses into two categories - detail lines for accounts that these managers can influence (controllable expenses) and other expenses (which they don't really have a direct impact on. The other expenses can include items that have been negotiated by corporate or senior management, such as various insurance costs (liability, etc.) and that are allocated to departments using some arbitrary method. Senior management and owners get to see everything.
This allows for a discussion on how the managers can affect profitability with out them dismissing or getting frustrated over items that are pushed down upon them.

Anonymous
(Financial Accounting Manager) |

The varied responses and your hypothetical scenario of lease vs. buy between divisions is a perfect example of creating reporting that fits your company. You know it best, make sure your end result accomplishes fairness when comparing to other products, divisions or those in your industry. Our internal P&L is split between controllable and uncontrollable costs. The uncontrollable are managed on separate review/approval processes.

Topic Expert
Jake Feldman
Title: Managing Director
Company: Global TaxFin Advisory Group LLC
(Managing Director, Global TaxFin Advisory Group LLC) |

Choosing performance metrics is indeed an old subject and one that is prone to abuse by executives that focus entirely on maximizing the chosen metric in order to maximize their incentive compensation. Both income and cash flow measures have their place as some of the comments have already noted, and many companies will use/weight both in their incentive plan. The issue is how to avoid bad decisions by executives when a particular metric is chosen.

For example, if the focus is on cash flow, why don't you consider a more complete free cash flow metric? Such as, income + depreciation - capex - working capital changes. Otherwise, what's to prevent a division head from offering generous sales terms that will most likely boost income but depletes cash flow, yet doesn't show in a simplistic EBITDA measure.

The comments here just scratch the surface in terms of advantages and disadvantages of different income and cash flow metrics. Just do a search on "how to measure a company financial performance" to get tons of hits. You might also want to consider more sophisticated measures, such as Economic Value Added (EVA).

Of course, when you have the dialog with your CEO, you should phrase things that while he would naturally never resort to the possible misguided underhanded tactics (LOL cynic!), can he say the same about his subordinates?

Lyle Newkirk
Title: CFO
Company: Corrigo Incorporated
(CFO, Corrigo Incorporated) |

Do it the way the CEO asks. The CEO has to hold managers accountable so provide data that helps do that. Many organizations manage to EBITDA which by definition excludes deprecation. Other executives like to manage to what is actually currently being spent. If you manage to EBITDA, separately track capital expenditures.

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