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Saving Depreciation Accounting

Avoiding ‘earnings management’ requires transparency in reporting standards.

Fortnightly Magazine - April 2009

sufficient understanding will be necessary to rectify the situation. Direct involvement in the determination of depreciation rates for the group concept is required to fully understand it, and those having this involvement tend to be members of the Society of Depreciation Professionals. Therefore, society members provide a resource of expertise that the accounting profession can draw upon to develop sufficient understanding of the group concept to allow it to be applied to all types of PPE under international standards.

Amortization commonly is adopted in the United States for PPE for which retirements go unreported (most often as a consequence of a capitalization policy that relies on monetary amounts rather than on physical descriptions of PPE components), thereby improving the match between depreciation and usage. Therefore, amortization should be acceptable under international standards. However, lack of understanding may get in the way of recognizing this.

The financial statements of entities practicing the component concept disclose the accuracy of their depreciable lives. Having substantial investment in fully depreciated PPE that remains in service indicates lives that are too short, and recording substantial losses for PPE retired prior to being fully depreciated indicates lives that are too long.

A special study is required to determine the validity of the depreciation rates of entities practicing the group concept. The depreciation accruals resulting from such a study can be expected to more accurately reflect PPE usage than will the component concept. There are two basic approaches for determining group depreciation rates, both of which attempt to predict the future. One approach emphasizes measuring the past and the other emphasizes understanding the past. Emphasizing measurement is the equivalent of trying to drive by looking only in the rearview mirror, so midcourse corrections must be more frequent than when emphasizing understanding. Therefore, the appropriate interval is two to three years between reviews of the continued validity of the depreciation rates of entities emphasizing measurement, and is about twice as long for entities emphasizing understanding.

International standards require that depreciable lives be reviewed at least annually. When adopting its rules for replacement cost accounting, which led to the FASB issuing SFAS 33, Financial Reporting and Changing Prices , the SEC recognized that reporting entities likely will have fully depreciated PPE that remains in service, and provided guidance for how to deal with such PPE. This recognition suggests that U.S. entities practicing the component concept in the past haven’t increased the depreciable lives of components expected to remain in service beyond the original estimates. Annual review of depreciable lives seems reasonable for entities practicing the component concept that adopt lives shorter than are expected, so that life can be increased when a component approaches, and is expected to exceed, its existing life. However, the SEC’s recognition of fully depreciated PPE suggests that making such midcourse corrections would require altering past U.S. practices.

International accounting standards specify that legal and constructive asset retirement obligations be recorded as liabilities, rather than as depreciation. Including constructive obligations is a significant difference from U.S. GAAP. The exposure draft of what eventually became SFAS 143, Accounting