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Fixing Depreciation Accounting

Accumulated provisions for depreciation belong on the right side of the balance sheet.

Fortnightly Magazine - October 2008

Until the late 1940s, the accepted accounting convention was to locate the accumulated provision for depreciation on the right (liability and capital) side of the balance sheet. The convention since has been to locate it on the left (asset) side as a contra-asset. This change was controversial, and has led to some strange accounting for the expenditures incurred to remove or abandon in place property, plant, and equipment (PP&E) at the end of its useful life (referred to here as removal costs or expenditures).

Recent events suggest now is an opportune time to revisit where the accumulated provision belongs. For example, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board are working to harmonize their respective standards. The Securities and Exchange Commission (SEC) announced its intention to allow financial reporting based on international accounting standards without reconciliation to U.S. generally accepted accounting principles (GAAP). And the SEC’s advisory committee on improvements to financial reporting recommended that accounting rules avoid special treatment for specific industries. Finally, financial accounting has moved away from emphasizing the concept of matching to emphasizing fair value.

In this context, accounting practices might be poised for a change, putting accumulated provisions for depreciation back on the right side of the balance sheet.

Allocation, Not Valuation

The balance sheet location controversy didn’t cease with moving the accumulated provision to the left side. For instance, a January 1959 Accounting Review article suggested that the location change be revisited. 1 In the article, a random sample of the then-recent annual reports of 90 industrials and railroads and 10 utilities showed one industrial, one railroad and three utilities continuing to report the accumulated provision on the right side, rather than as a contra-asset on the left side. Right-side treatment by utilities is not surprising, because utilities objected to the change 50 years ago.

Depreciation accounting is a cost-allocation concept—not a valuation concept—and an objection to left-side treatment was that it can lead some to incorrectly interpret the resulting net asset amount as being the current value of the assets. An objection to right-side treatment was that the accumulated provision is not a liability, so does not belong on the right side. The accumulated provision obviously isn’t a liability, but it is a source of funds, and sources of capital are recorded on the right side. The removal or abandonment obligation clearly is a liability. However, the liability is the estimated expenditure measured at the price level expected at the time of expenditure, not the amount of the estimated expenditure already recorded as an expense and charged by regulated enterprises to their ratepayers.

For enterprises subject to price regulation, the accumulated provision clearly is a source of funds because rate-base regulation

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