The Basics

Once a company embarks on CAPEX (Capital Expenditure) here is what happens in the financial statements:

1. The amount spent is reported as CAPEX in the Investing Section of the Cash Flow Statement.

2. A corresponding entry is made in the Assets Section of the Balance Sheet in the PPE (Property, Plant, and Equipment) line item unless the company desires to break it out as a separate line item.

3. Also, if cash was used, the cash line item gets deducted or if debt was used, the amount hits the Liabilities Section of the Balance Sheet.

4. At this time there is no impact on the Income Statement.

Till now, all is simple. The fun starts as time passes by and step two of the process begins.

1. Depending on the asset's useful life and type, the asset is depreciated using various methodologies. The most common and simple method used is the Straight-Line Method. The asset gets depreciated equally each year.

2. As the depreciation happens, it gets added as an expense above the Operating Income line. Depending on the asset depreciated, it may get included in COGS (Cost of Goods Sold).

3. Correspondingly, the value of the asset is reduced in the Balance Sheet.

Now, why did I say the fun starts with the second step? Consider the following:

• What is the useful life of the asset? 2 years? 3 years? 6 years? Upto management’s discretion as long as they can convince the auditor. I will highlight an egregious abuse of this freedom and a - somewhat - questionable use of it.

• Life is not always rosy. Bad stuff happens. What if the piece of equipment the management assumed would last for 6 years becomes impaired or no longer useful towards the company’s future goals in year 3? The correct thing to do is to abandon the original depreciation schedule and expense the remaining asset balance thus causing a hit to Operating Profits. Guess what they do in case the impact will be material? Announce restructuring or “Operational Excellence” programs to clean house. Wall Street couldn’t care less about restructuring charges below the Operating Income line. Do you think I am making this up? What was META doing till the middle of 2024 from 2022?

Oh, BTW, fun and games can be played with step one to hide future depreciation expenses. For instance, the company may stick the CAPEX into a subsidiary. Those shenanigans are not the purview of this article though.

Talking about shenanigans, here is an example of a famous case of abuse of “useful lives” freedom from the ‘90s.

Waste Management Depreciation Scandal

Most people, if not all, have seen those big Waste Management trucks on the roads. They collect garbage, haul it, and dump it into landfills. However, in the ‘90s, the company itself was garbage. In 1998, Waste Management got caught inflating earnings by $1.7 billion from 1992 to 1997. What were they doing?

• They kept increasing the useful lives of their trucks to reduce depreciation expenses. They went from assigning 6 years to 8 years to 10 years of useful lives to the trucks.

• Increased the end-of-life salvage value of the trucks. Thus reducing depreciation expenses even further.

• Stopped recording expenses even though landfill values were falling.

• Didn’t record costs related to unsuccessful or discarded developmental landfills as expenses.

• Deferred operating expenses, i.e. they capitalized expenses incorrectly.

You may be wondering how they got away with it for so long. It always takes time. SEC is short-staffed and those who warn are laughed at. Also, Waste Management was like a proverbial old boys’ club. The management, the board, and the auditors were all in it. It was not until a new CEO was appointed in 1998 that the fraud was exposed. The details were so juicy that the scandal shook the financial world.

The important point: head-scratching increases in the “useful lives” of garbage trucks. Whenever a company makes changes like that, one’s antenna should go up, irrespective of the management’s explanation. The question to ask: does it pass the smell test, specifically, does it make economic sense?

That brings us to big tech.

Big Tech’s Useful Lives Changes

So, what have all the big guys been doing since 2020 regarding the useful lives of servers and networking equipment?

• MSFT - Increased it from 3 to 4 years in 2020. Increased it to 6 years in 2022.

• AMZN - Increased it from 3 to 4 years in 2020. Increased it to 5 years in 2022. Increased it to 6 years in 2024.

• IBM - Increased it from 3 to 4 years in 2023. Increased it to 6 years in 2024.

• GOOG - Increased useful lives of servers from 3 to 4 years and networking equipment from 4 to 5 years in 2021. Increased it to 6 years in 2023.

• META - Increased it to 5.5 years in 2025.

They all saved tens of billions in depreciation expenses, which helped inflate their operating income. Why did they increase the useful lives?

Fair enough. Hypothetically, what if ground-breaking technology in this space arrives in the next one to three years enabling the build-out of whatever all of these companies are at one-tenth the cost and with 10x performance improvements? DeepSeeked, right? Wouldn’t investors line up to fund a startup with a clean slate to build out the same capacity for ~$30 billion?

For 2025, the announced combined AI CAPEX is ~$300 billion. Starting in 2026 they will be on the hook for ~$50 billion in depreciation expenses per year including existing obligations. If these companies were using the pre-2020 depreciation schedule of 3 years, they would have been on the hook for ~$100 billion per year plus existing obligations.

By extending the depreciation schedule these companies have put themselves in the danger of possibly having to take large depreciation expenses due to technological obsolesce. “Waste Managementesque”, not in a scandalous way, but in the massive write-down sense. However, they will not let that hit their operating income by announcing restructuring programs again.

This article is not to rain on the AI parade. I wish I had these GPUs in the ‘90s. The key points here are:

• Investors should be aware of the risks associated with the elongated depreciation schedule. Just because everybody is doing it doesn’t make it right.

• The CAPEX numbers are just too large even for these guys.

• ROI (Return on Investment) will become a mainstream talking point.

• I don’t expect further Multiple Expansion in this space in 2025. Rather, I wouldn’t be surprised if these companies start to underperform.