As I have mentioned in previous articles, each year I set the final-year students at the UK’s University of Liverpool an assessment based on analysing the financial statements of a company of their choice.
Despite their initial refusal to accept my claims that they will actually enjoy it, it’s not long before many of them have dived deep into the details of accounting standards and disclosure notes. Soon enough, they too are telling their non-accounting loved ones all about their chosen company and getting the same disappointedly bored reaction that many of us have had when talking about these things for years.
Microsoft’s revision of its useful lives led to an increase of billions to its operating profit line
As the students find themselves scrutinising the annual reports to a level of detail that not many others will employ, they discover the prominent use of alternative performance measures in many companies. This then usually forms a sizeable chunk of discussions in class as the module progresses.
Another common feature of their analysis is that students are often able to see how the technical accounting standards they learn can really impact the financial statements they are looking at.
Useful life changes
Two years ago, one student noted that Microsoft’s revision of its useful lives led to an increase of billions to its operating profit line. The student was able to see just how the judgments made by management in applying these standards can impact. Since then, this trend has continued within the tech industry and has recently been noted by the Financial Times.
Knowledge of amortisation led Chelsea Football Club to offer eight-year contracts in order to spread the cost
The useful life is not deemed to be an accounting policy of an entity, but rather an estimate, looking at the expected usage of the asset. If it was deemed to be an accounting policy, in accordance with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, the previous year’s financial statements would need to be restated as if the policy had always been in place. As the useful life of an asset is an accounting estimate, this change is applied prospectively, meaning that profits increase as these lives are re-estimated to be longer than previously thought.
Amortisation
This simple set of accounting rules has found increasing popularity within football finance, with the principle of amortising player contracts being central to whether clubs are in compliance with financial fair-play rules. This knowledge of amortisation even led Chelsea Football Club to famously offer eight-year contracts in order to spread the cost of a player over a longer period and therefore reduce the impact on profit.
While this did have that impact (and led to a subsequent Premier League rule change requiring amortisation over a maximum of five years), it could be argued that trying to work this accounting loophole could lead to longer term problems.
Although the annual expense may be lower, and the player asset value remains higher, this could absolutely result in issues if these players perform below expectations. While it is unlikely that these assets are would be impaired, it may mean that if they are sold, this would result in significant losses on disposal, which would hit the profit. In this case, the club may prefer to hold the asset rather than recognise the profit hit, which is surely a poor strategic decision.
The final example to bring in is Netflix. Clearly a huge element of the company’s expense is the production of content for the platform. This could be either content produced in-house or licensed from a third party.
It is difficult to assess a useful life of a movie on Netflix
Rather than being immediately expensed, these costs hit the statement of profit or loss via amortisation. As this is the primary expense, the amortisation method applied can have a significant effect on Netflix’s overall profit. The total content amortisation in 2023 amounted to US$14.2bn out of US$19.7bn cost of sales.
According to its annual report, Netflix amortises production costs over the shorter of each title’s contractual window of availability, or estimated period of use, or 19 years. Netflix states that on the basis of expecting more up-front viewing, over 90% of this content is expected to be amortised within four years.
This seems reasonable but it is difficult to assess a useful life of a movie or content on the platform, particularly in terms of whether it helps to keep the user base. Netflix itself warns against trying to produce calculations to find the average amortisation period due to accelerated amortisation and showing its assets on a net basis. Either way, it is certainly possible that the significant judgment on the useful life of a show could have a significant impact on profits.
Overall, the useful life of assets maintains its status as having a strong impact on the potential profits of an entity. Alternative performance measures such as EBITDA may have their critics, but with this amount of judgment on the table, it is easy to see why they persist.
Watch and learn
Watch Adam Deller’s series of videos explaining the fundamentals of IFRS Standards
