(January 2011) Gold Mine or Fool’s Gold?: Debt is recorded on the right side of the balance sheet in recognition that it’s a source of capital, but users of financial statements...
Fixing Depreciation Accounting
Accumulated provisions for depreciation belong on the right side of the balance sheet.
treatment of removal costs—the requirement to be systematic and rational, consideration of salvage, and recognition that depreciation accounting is a process of allocation, not of valuation.
The rational aspect of “systematic and rational” means that depreciation is to be recorded in a manner that matches the pattern of usage or revenue-generating capability of the related assets, consistent with the regulatory principle of intergenerational ratepayer equity. Thus, if the asset usage or revenue pattern is decreasing, the depreciation method should be accelerated relative to the life span of the asset. If the pattern is constant, depreciation should be constant relative to the life span, and if the pattern is increasing, depreciation should be deferred relative to the life span.
The PP&E of regulated entities exhibits decreasing or constant patterns over their lifetimes—not increasing patterns. Therefore, U.S. GAAP dictates that the depreciation rates of such entities (and probably of all entities) be constant (ratable) over life defined by either time or asset usage.
The U.S. GAAP definition reference to salvage is intended to mean “net salvage,” thereby encompassing removal costs. If the definition had been meant to incorporate only salvage into depreciation, it would have stated “gross salvage” rather than merely “salvage.” This terminology has proven to be unfortunate, because it has created confusion concerning how removal costs are to be dealt with for accounting purposes. As a result, the true intention of the GAAP definition has been lost, and strange accounting has occurred.
Several facts support the “net salvage” definition of “salvage” within GAAP. At the time of the definition, the term “salvage” generally was used to mean “net salvage” ( i.e., salvage proceeds less removal expenditures), and utilities typically incorporated removal costs into depreciation for regulatory accounting purposes. Additionally, the “net salvage” definition supports greater consistency in treating different end-of-life transactions (salvage and removal costs) ratably through depreciation. Treating removal costs differently from investment and salvage conflicts with the premise that accounting practices should be reliable and relevant.
The ratable treatment of removal costs through depreciation for regulatory accounting purposes has a long history, but periodically is challenged by proposals to defer recording and recovery. Such challenges also have a long history, but have taken on renewed vigor as a consequence of FASB Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations , (SFAS 143), issued in 2001.
Challenges to ratable treatment of removal costs for regulatory purposes are unfortunate, because they lead to proposals for deferral mechanisms that, if accepted by regulators, increase the costs to be borne by ratepayers over the life of the related PP&E, thereby increasing energy costs and damaging the competitiveness of the state 3 (see “ Depreciation Shell Game ,” Fortnightly, April 2008).
Removal cost deferrals result from regulatory decisions that emphasize near-term political considerations over long-term economic considerations. The financial community and large energy users can be expected to interpret such regulatory unfairness as signaling deterioration of the business climate. The financial community might react to such a signal by downgrading the securities of jurisdictional entities and of the state itself. Additionally,