Technological obsolescence has a more profound impact on the future economic life of long-term operating assets today than it had in the past. Therefore, the periodic capacity costs required to sustain current revenues should not only include the wear and tear costs of using long-term operating assets but also the costs related to their technological obsolescence. In reality, however, firms often record depreciation and amortization (D&A) expense that do not capture the effect of technological changes, resulting in misleadingly low D&A expense and overstated earnings.
In this paper, I propose a measure of maintenance capex that attempts to measure the economic capacity cost required for a firm to sustain its current level of revenue. I find that the median firm recognizes 25% lower D&A expense compared to the estimated level of maintenance capex. This results in overstatement of operating income by 7%. I show that under-depreciating firms, which report lower D&A expense than their estimated maintenance capex, experience future write-offs and negative future earnings.
Moreover, under-depreciation is also associated with significantly negative future abnormal stock returns, suggesting that stock prices do not fully reflect the implications of the under-depreciation for future earnings. In sum, my measure can help financial statement users identify under-depreciating firms, anticipate negative future earnings, and adjust reported earnings for valuation purposes. Additionally, I show that the well-documented negative relationship between investment and future stock returns is partly attributable to investors’ inability to differentiate between maintenance and growth capex.
| Identifer | oai:union.ndltd.org:columbia.edu/oai:academiccommons.columbia.edu:10.7916/d8-8deb-kf24 |
| Date | January 2021 |
| Creators | Peddireddy, Venkat Ramana R. |
| Source Sets | Columbia University |
| Language | English |
| Detected Language | English |
| Type | Theses |
Page generated in 0.0022 seconds