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The Accounting Neverland: Software that refuses to grow up

One way to perform due diligence on a company is to look at the estimated useful life assumptions behind the depreciation and amortization calculations.  Overly optimistic assumptions will inflate reported earnings while overly conservative assumptions will deflate reported earnings.

One outlier is Continental Resources (CLR).  This oil and gas producer estimates that the useful life of its “Enterprise resource planning software” will be 25 years.  So let’s take a trip down memory lane and examine what software looked like two and a half decades ago…

Microsoft’s Windows 3.0 software was announced in 1990, 26 years ago.  According to a BBC News article: “Microsoft maintained support for Windows 3.x until the end of 2001, and it has lived on as an embedded operating system until 1 November 2008.”  Not surprisingly, Microsoft’s 16-bit operating system was eventually made obsolete by newer technology such as Microsoft’s 32-bit and 64-bit operating systems.

Of course, past performance is not necessarily indicative of future results.  It’s possible that modern-day software stays relevant for a longer period of time.  In practice, many companies continue to use software that the vendor no longer supports.  Performing a Document Search for “Windows 2000” will find companies that continued to use the operating system even after Microsoft ended support in 2010.

For example, Quality System’s 10-K filed May 22, 2015 (EDGAR, mentions the Windows 2000 and Windows XP operating systems, neither of which are currently supported by Microsoft:

NextGen® Ambulatory Practice Management Systems. NextGen® PM is the NextGen Division’s practice management offering. NextGen® PM has been developed with a functional graphical user interface (“GUI”) certified for use with Windows 2000 and Windows XP operating systems. The product leverages a relational database (Microsoft SQL Server) with support on both 32 and 64 bit enterprise servers. NextGen® PM is a scalable, multi-module solution that includes a master patient index, enterprise-wide appointment scheduling with referral tracking, clinical support and centralized or decentralized patient financial management based on either a managed care or fee-for-service model. The NextGen® PM product is a highly configurable, cost-effective proven solution that enables the effective management of both single and multi-practice settings.

Ultimately, anything can happen.  There are uncertainties that surround the true life of Continental’s ERP system.  Who knows?  Perhaps Continental’s ERP software will last even longer than 25 years.

Peer comparisons

Sentieo can be used to quickly track down peers that report their estimated useful life assumptions for their ERP systems.  A broad search for “enterprise resource planning” can return a lot of irrelevant results.  Most companies lump ERP into a computer software and hardware category, which they often depreciate on a straight-line basis over 3-5 years.  It is rare for public companies to break out ERP into its own category.  However, it is much more common for companies to discuss their ERP systems in other contexts.  Sentieo can make the search process much faster by limiting the search results to tables within 10-K annual reports.  Such tables are more likely to contain estimated useful life assumptions.

Step 1: Filter by 10-K filings

Step 2: Filter by table search

There are 24 companies that have 10-Ks that meet this criteria.  Out of those 24, five of these companies are disclosing their ERP software assumptions.

Ticker Company Name Estimated useful life (years) Sentieo link EDGAR link
FIRE Sourcefire Inc 5 10-K
SPDC Speed Commerce Inc 7 10-K
SMTC Semtech Corporation 13 10-K
SCHN Schnitzer Steel Industries Inc 11 to 17 10-K
CLR Continental Resources, Inc 25 10-K

As you can see, there is a wide range of assumptions.  The most optimistic assumption is 5 times that of the most conservative assumption on this list.  It appears that the accountants at these companies have very different ideas about the longevity of their employer’s ERP system.

Researching quality of earnings in other industries

The same process can be applied to other industries such as mining.  Companies with mine operations need to depreciate buildings and other tangible assets located on the mine site.  The useful life of many of these assets are tied to the mine’s life.  It is a potential red flag if these assets are being depreciated over a period of time longer than 20 years.  When a mine is originally built, the planned mine life will often be between 6-20 years.  It may not make sense to design for a mine life longer than 20 years since mining at a slower rate reduces the Net Present Value of the project.  Because each mineral deposit varies, the optimal mine life will depend on various factors specific to that mineral deposit.  You should perform your own due diligence in determining what estimates are reasonable or unreasonable (e.g. consult a professional mine engineer, read textbooks on mine engineering, review technical information about a project, etc.).  Sentieo can accelerate your research process by helping you:

  1. Find outliers in accounting estimates.  Sentieo speeds up the process by allowing you to limit searches to text within tables and/or particular filing types (e.g. 10-K, 20-F, and 40-F annual reports).
  2. Examine how other public companies handle the accounting for similar assets.  For example, some mines have joint venture partners that are publicly-traded.  The joint venture partners may have different numbers for the same asset.  Where direct peer comparisons do not exist, analysts can look at public companies that own similar mines (e.g. mines utilizing similar mining techniques, with similar grades, etc. etc.).

In general, most industries will have a range of different estimated useful life estimates for very similar assets.  In the annual report, these assumptions are often (though not always) disclosed in a table.  Other methods of finding these disclosures include (A) using the Crtl + F search function in your browser and (B) using Sentieo’s Snippet Search on phrases commonly associated with estimated useful life disclosures such as “straight line”.

Snippet Search in action.

A careful examination of different companies’ accounting estimates can reveal companies whose accounting is significantly more aggressive or conservative than their peers.

The bottom line

As you can see, Sentieo can let you zero in on key pieces of information to quickly identify potential issues and potential red flags.  The platform provides the ability to search through accounting disclosures in annual reports while filtering out unwanted noise, allowing you to spend more time figuring out whether a company’s earnings are reality or simply a fairy tale.