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Fixing Depreciation Accounting

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

Fortnightly Magazine - October 2008

47) in 2005. FIN 47 improved the consistency of reporting, but did not eliminate the problem—which is due, in part, to the difficulty in applying SFAS 143 by entities practicing the group concept of depreciation accounting. However, the remaining inconsistency pales when compared to the inconsistency resulting from the misinterpretation of the GAAP definition of depreciation accounting.

This misinterpretation means that regulated entities record removal or abandonment obligations ratably over the life of the related PP&E, except for a few that are subject to the jurisdiction of regulatory agencies that have imposed deferral mechanisms. At the same time, non-regulated entities record such obligations using one of two deferral mechanisms—SFAS 143 treatment for legal obligations, and cash treatment for other obligations. Entities practicing the item concept of depreciation accounting record and depreciate each item of PP&E separately, so related legal removal obligations easily are identified, recorded and tracked. Entities practicing the group concept easily can identify, record, and track such obligations for PP&E recorded and depreciated by location, such as for power plants, but it is next to impossible to track such obligations for PP&E not so recorded and depreciated, such as for electric and gas distribution systems.

SFAS 71, Accounting for the Effects of Certain Types of Regulation , allows qualified entities to utilize accounting practices that cannot be utilized by non-qualifying entities. The effect of qualification is that the income statement reflects regulatory accounting requirements, with any differences from financial accounting requirements being disclosed on the balance sheet as regulatory assets or liabilities. For example, obligations qualifying for liability treatment under SFAS 143 typically are reflected in depreciation for ratemaking purposes, so depreciation treatment would be reflected on the income statement and a regulatory liability disclosed. Disclosing a regulatory liability means that regulated entities must maintain accounting records for both depreciation treatment and liability treatment of legal obligations. SFAS 71 would be rescinded, if the SEC follows the recommendation of its advisory committee to avoid special treatment for specific industries. Rescinding would be a problem for regulators, because the financial statements of regulated entities could no longer match removal costs to the usage of the PP&E providing service to ratepayers, thereby violating the principle of intergenerational ratepayer equity.

It wouldn’t be difficult to eliminate the strange removal cost accounting and the potential for violating the principle of intergenerational ratepayer equity. Doing so would allow financial statements to more accurately depict the financial position and results of operations of the reporting enterprises and ensure that ratepayers bear the costs being incurred to serve them. All that’s necessary is to recognize that the accumulated provision for depreciation is a source of funds that belongs on the right side of the balance sheet, and to change the reference to “salvage” in the GAAP definition of depreciation accounting to “net salvage.”

These two actions would allow FASB to rescind SFAS 143, and would promote consistency, comparability, reliability, and relevance by requiring all enterprises to use the same removal cost treatment for accounting purposes.



1. Simon, Sidney, “The Right Side of Accumulated Depreciation” Accounting