Information Content and Value Relevance of Depreciation: A Cross-Industry Analysis

Abstract

Funds from Operations (FFO) is the prevailing performance measure in the Real Estate Investment Trust (REIT) industry. However, prior studies are inconclusive about the superiority of FFO over GAAP net income. Because depreciation is the largest reconciling item between FFO and net income, we examine the information content and value relevance of depreciation for both the REIT and non-REIT industries and report the following findings. First, tests of association between the level of stock price and the balance sheet components demonstrate that accumulated depreciation is value-relevant for the REIT industry, whereas accumulated depreciation has little value relevance for comparably capital-intensive non-REIT industries. The evidence is consistent with a characterization that REITs' net book value is understated by GAAP accumulated depreciation, and correspondingly, investors adjust stock prices upward for such an understatement. Second, using non-market data, we demonstrate that accounting depreciation deviates from economic depreciation to a greater extent for REITs than for non-REIT industries. Third, accumulated depreciation has predictive ability for future revenues for REIT firms, but not for non-REIT firms. Finally, an industry-level analysis reveals that no industry other than the REIT displays all of the properties described above. In sum, evidence using both stock market and non-market data supports the REIT industry's assertion that GAAP depreciation consistently exceeds economic depreciation and that book value of assets is systematically understated.

Keywords: funds from operations; REIT; value relevance; accounting depreciation; economic depreciation.

JEL Classification: M41