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Saving Depreciation Accounting

Avoiding ‘earnings management’ requires transparency in reporting standards.

Fortnightly Magazine - April 2009

cumbersome and a waste of resources.

Depreciation Accounting Implications

The Uniform Systems of Accounts promulgated by U.S. regulators require that jurisdictional entities practice the group concept of depreciation accounting for all their PPE, whereby similar classes of PPE are grouped for depreciation purposes. Under the component concept required by international standards for PPE other than mass PPE, each component is depreciated individually, interim additions and replacements are expensed, gains or losses are recorded for components retired prior to reaching their depreciable life, and depreciation ceases when the depreciable life is reached. International acceptance of the group concept for mass-type PPE is predicated on its ability to match the recording of depreciation to the life experienced by the group. This matching is interpreted as being sufficient for allowing group depreciation for mass-type PPE, but is identical to the “rational” requirement of the U.S. GAAP definition of depreciation accounting, which allows group depreciation for all PPE. Another important aspect of U.S. GAAP is that depreciation accounting is stated to be a process of cost allocation—not of valuation.

Regulated entities have two basic types of PPE—location-type and mass-type—to which three basic group depreciation approaches are applied—life span, average life, and amortization. Life span commonly is adopted for some classes of location-type PPE, such as power plants, with interim additions, replacements, and retirements being recognized in the depreciation rates. Average life, whereby variation of the age of retirements around the average life is recognized by dispersion patterns, is applied to most classes of location- and mass-type PPE. Amortization is applied to mass-type PPE for which lack of retirement reporting has prompted the recording of retirements to be based on attained age rather than field reporting.

The component concept likely will provide a practical substitute for life span, because it is merely life span without the recognition of interim additions, replacements, and retirements through depreciation. However, the component concept would not be practical for location-type PPE, for which average life typically is utilized, such as electric transmission lines and substations, gas measuring and regulating stations, and general purpose buildings, because there are too many locations. For example, it’s not unusual for an electric utility to have several hundred substations.

Entities practicing the component concept typically adopt depreciable lives that are shorter than expected, to limit or eliminate the recording of gains or losses and differences between book and tax depreciation. While inconsistent with the concept that the recording of depreciation matches PPE usage, depreciation based on such lives is considered conservative and acceptable for financial reporting purposes. When properly applied, life span for regulatory purposes more accurately matches the recording of depreciation with PPE usage than does the component concept (see sidebar, “Group Depreciation is More Accurate”) , and so should not be precluded by international standards.

Life span applied on a group basis that recognizes future interim additions, replacements, and retirements is consistent with the purpose of depreciation accounting under international standards, but is not allowed currently. This suggests the group concept is insufficiently understood, and that a concerted effort on the part of those having