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Saving Depreciation Accounting
Avoiding ‘earnings management’ requires transparency in reporting standards.
for Asset Retirement Obligations , called for liability treatment of both legal and constructive obligations. However, SFAS 143 was limited to only legal obligations when the FASB concluded that constructive obligations could not be defined tightly enough for consistent application. Limiting SFAS 143 to legal obligations did not prevent inconsistent applications, as is evident from the FASB issuing Interpretation 47, Accounting for Conditional Asset Retirement Obligations (FIN 47). FIN 47 improved the consistency of reporting, but did not eliminate the problem, which is a consequence of the difficulty in applying SFAS 143 by entities practicing the group concept of depreciation accounting.
The liability accounting treatment dictated by U.S. GAAP and international standards is as a prepaid annuity, which is back-end loaded. This back-end loading causes a mismatch with the usage of the related PPE and a gain or loss (perhaps substantial) to be recorded if the removal date isn’t estimated accurately. Therefore, arbitrarily short depreciable lives don’t provide a suitable basis for recording asset-retirement obligations. The degree of back-end loading of the accounting for legal (and perhaps constructive) obligations might encourage earnings management, in order to limit the income statement volatility inherent in inaccurate removal date estimates.
The cost of removal not qualifying for liability treatment is expensed under both U.S. GAAP and international accounting standards. This requirement for U.S. GAAP is a consequence of misinterpretation of the meaning of “salvage” in the GAAP definition of depreciation accounting that is partly a consequence of the shift shortly after World War II from the accumulated provision for depreciation being recognized as a source of capital on the right side of the balance sheet to being a contra-asset on the left side (see “Fixing Depreciation Accounting,” Fortnightly, October 2008) .
Certain actions can be taken to assure that existing utility asset and depreciation accounting practices that enhance the ability of financial statements to depict accurately the results of operations and financial status, will survive a substitution of IFRS for U.S. GAAP. These actions include:
• Adopt policy statements (by the SEC and Public Company Accounting Oversight Board) concerning the exercise of judgment, as is recommended by the SEC’s Advisory Committee;
• Determine whether the effect on audit quality of the limitations by the Sarbanes-Oxley Act on the services that audit firms can provide to their audit clients is acceptable, and, if not, recommend modifications to the Act;
• Prohibit fair-value accounting for PPE;
• Allow group-depreciation accounting for all classes of PPE;
• Affirm that depreciation accounting is a process of cost allocation—not of valuation;
• Record all removal or abandonment costs ratably through depreciation over the life of the related PPE; and,
• Recognize the accumulated provision for depreciation as a source of capital on the right side of the balance sheet.
These actions will allow regulated entities to retain their asset and depreciation accounting practices and other entities to adopt practices that will enhance the accuracy of their financial statements. They also are consistent with the stated purpose of the substitution, and are appropriate even if international standards are not