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Fixing Depreciation Accounting

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

Fortnightly Magazine - October 2008

treats the accumulated provision as being ratepayer-supplied capital, for which a credit is provided at the allowed cost of capital. Recognizing depreciation as a source of funds also is evident from the U.S. government allowing income-tax depreciation to be accelerated in order to provide funds (tax savings) for business expansion. This view was reinforced when the initial attempts by price regulators to pass the tax savings on to ratepayers prompted the IRS to deny accelerated tax depreciation to entities not allowed to retain the resulting tax savings.

Being recorded as a contra-asset has led to concern that net asset amounts could become negative, which has led to some strange accounting for expenditures for removing or abandoning PP&E. For long-lived assets, salvage usually is inconsequential, and removal expenditures frequently exceed the historical cost of the related assets. Therefore, accurately recognizing these expenditures for accounting purposes is at least as important, if not more important, than is recognizing the consumption of the related PP&E when providing a product or service. However, accounting practices don’t recognize this importance.

Regulatory agencies were well ahead of the accounting profession in recognizing that the concept of retirement accounting made no sense, and so adopted depreciation accounting. Under retirement accounting, investment is recorded as an expense upon retirement, salvage is recorded as income when received, and removal cost is recorded as an expense when incurred. Regulators also were ahead in recognizing there are three components to depreciation—investment, salvage, and removal expenditures—and that accurately charging these costs to ratepayers necessitates recording them ratably over the useful life of the related PP&E.

This recognition means a known investment cost is accrued (recorded as a periodic expense) after being incurred, an estimated future salvage amount is accrued (recorded as a periodic credit) before being received, and an estimated future removal expenditure is accrued (recorded as a periodic expense) before being spent. This treatment assures that ratepayers are charged no more and no less than the costs being incurred to serve them, at the time the service is rendered and the costs are incurred—which is known as the regulatory principle of intergenerational ratepayer equity.

Regulatory depreciation accounting rules are more detailed than are financial accounting rules, and are specified by the Uniform Systems of Accounts (US-ofAs) prescribed by FERC and other entities. Almost all USofAs dictate that salvage and removal costs be treated as components of depreciation, 2 and this treatment predates World War I. The basic foundation for the regulatory accounting treatment of salvage and removal cost is evident from the FERC USofAs for electric utilities and natural gas companies, which define depreciation as “loss in service value,” define service value as “the difference between original cost and net salvage value,” and define net salvage value as “the salvage value of property retired less the cost of removal.”

Salvage vs. Net Salvage

It took a while, but the U.S. accounting profession eventually caught up with the regulators, evident from the definition of depreciation given in a sidebar that was issued during the 1950s. Three aspects of this definition are significant to the