Could Depreciation Policies Be Concealing Company Profitability?

Entrance

Profitability ratios, cash flow, and financial sustainability are among the most important factors influencing investors' decisions regarding a company. However, these indicators can be easily manipulated by the accounting policies behind balance sheets and income statements. One of the most notable tools in this regard is depreciation policies.

Depreciation, from an accounting perspective, is the systematic process of expensed as the value of fixed assets decreases over time. However, choices such as which method to choose, what percentage to allocate, and how to report it during the period directly impact profitability. Therefore, it is essential that depreciation policies are examined separately from the investor's perspective in due diligence processes.

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1. The Fundamental Legal Nature of Depreciation

Depreciation is regulated both in Turkish tax legislation and under the Turkish Financial Reporting Standards (TFRS).

From the perspective of the Tax Procedure Law (VUK):

• Depreciable assets are amortized at specific rates based on their acquisition costs.

• This is included in the regulations between articles 313-328 of the Tax Procedure Law.

• The general rule is the standard depreciation method; however, the declining balance method may also be used in some cases.

From an IFRS perspective:

• Companies may apply different depreciation methods based on useful life and benefit period in order to present more realistic operating results.

• These methods include options such as the linear method, the declining balance method, and the production quantity method.

From an investor's perspective, the critical factors are which method was chosen, why it was chosen, and how that method affects the financial situation.

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2. Understating Profits Through Depreciation: Tax Advantage or Manipulation?

A company can quickly expense the value of its fixed assets, thereby understating its short-term profits and paying less tax. This, in a sense, provides a tax advantage.

But in the long run:

• The book value of assets depreciates quickly.

• Because profitability is shown as low, investors may misjudge the company's growth potential.

• The company's borrowing capacity may be affected.

Unusual changes in depreciation rates, especially in the periods leading up to company mergers, acquisitions, and initial public offerings, raise serious suspicions of manipulation.

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3. Evaluation Criteria from an Investor's Perspective

An investor should ask the following questions during the due diligence process:

• Which depreciation method was used?

• Have there been any changes to depreciation rates in the last 3 years?

• Is this method in line with industry averages?

• If a change has been made, what is the reason for that change?

• How does it make a difference to the company's net asset value?

The answers to these questions will enable investors to accurately understand the company's true performance.

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4. Case Study: Concealed Impairment and Investor Deception

An energy production company purchased a turbine worth 80 million TL and stated that it would apply depreciation using the straight-line method for 10 years. However, despite a 70% decrease in production capacity in the company's fourth year, the depreciation rates remained unchanged. Although the physical value of the turbine decreased, it was still shown as an asset value at 60% in the financial statements.

The investor overvalued the asset and paid a high price. However, the following year the company declared an impairment loss of 25 million TL. This led to a valuation error on the part of the investor.

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5. Common Risky Practices Related to Depreciation

a. Arbitrary Determination of Useful Life Estimates

For example, setting a 15-year amortization period for a software license expected to be used for 5 years means unnecessarily postponing expenses.

b. Deviations in Asset Grouping

Depreciating the same type of assets over different periods eliminates the comparability of balance sheet items.

c. Periodic Depreciation Shifts

Especially towards the end of the year, failing to allocate or reducing depreciation in order to influence profit and loss figures is also a form of manipulation.

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6. Audit Rules and Responsibilities

Turkish Commercial Code (TCC):

• The presentation of financial statements accurately and honestly is mandatory (Turkish Commercial Code, Articles 515-518).

• Company management that prepares misleading financial statements may face both liability lawsuits and criminal penalties.

Independent Audit Reports:

Unusual practices in depreciation policies are often noted in audit reports as "qualified opinion" or "significant uncertainty." However, investors are likely to suffer losses if they do not carefully read these warnings.

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7. Transparency in Financial Reporting: How Satisfactory Are the Management Disclosures?

Notes to the financial statements and management reports must explain the rationale behind depreciation policies.

From an investor's perspective:

• Are these statements clear?

• Does it comply with industry standards?

• Have comparisons been made with previous years?

Questions like these are important.

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8. The Impact of Depreciation Rates on International Investment Decisions

For foreign investors, amortization policies are crucial not only for taxes but also for dividend distribution, share valuation, and exit strategy.

Investor:

• If the company realizes it is artificially understating its EBITDA, it will lower the bid price.

• A company that over-depreciates its assets may create unfair competition by giving the impression of being "loss-making.".

• This is a frequently discussed topic, especially in technology and rapidly growing sectors.

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Conclusion

While depreciation may seem like a technical aspect of accounting, it can actually become a tool for obscuring a company's financial reality. In the due diligence process, not only the numbers but also the accounting policies behind those numbers should be examined, and depreciation methods should be analyzed through industry comparisons. Creating a trustworthy company profile for investors involves auditing not only the balance sheet but also the underlying assumptions.

Gamze Akbulut, Law Faculty Student