Over the next year (or years), companies in Canada and the U.S. will make the transition towards adopting International Financial Reporting Standards (IFRS). These standards will have a...
Saving Depreciation Accounting
Avoiding ‘earnings management’ requires transparency in reporting standards.
in order to provide more transparency into how such judgments will be evaluated for reasonableness. Price-regulated entities understand this need as a consequence of their experience with after-the-fact inquiries into the prudence of construction costs that made the nuclear generation option very risky, an experience that has prompted them to obtain commitments for cost recovery prior to embarking on expensive construction projects. The advisory committee recommendation is more important with principles than with rules, but this does not detract from its significance, even if international standards are not substituted for U.S. GAAP.
Asset Accounting Implications
International standards allow the recording of property, plant and equipment (PPE) to reflect either cost or fair value, whereas U.S. GAAP allows only the reflection of cost, and regulation requires a special version of cost that is known as “original cost” (the cost incurred by the entity that first dedicated the PPE to public service). However, U.S. GAAP requires certain financial instruments to be recorded at fair value (mark-to-market), and efforts are being made to expand the use of fair value for accounting purposes. The SEC’s advisory committee expressed concern about the use of fair value for financial-reporting purposes, even prior to the global financial market crisis, and that crisis is being blamed, at least in part, on the requirement of mark-to-market accounting for financial instruments. The Financial Accounting Standards Board (FASB) and SEC have reacted to this crisis by limiting (at least temporarily) the application of such accounting, which should lead to questioning the reasonableness of extending fair value accounting to PPE.
Determining PPE fair value requires an appraisal, and auditors of financial statements will have to judge the validity of claimed fair-value amounts. The savings and loan situation of the 1980s and the current sub-prime mortgage melt down demonstrate that claimed qualifications don’t provide auditors with a sound basis for judging the validity of the work of appraisers. Therefore, judging validity will require addressing appraisals directly. However, the Sarbanes-Oxley Act, which prevents audit firms from providing valuation services to their audit clients, might keep such firms from having the expertise on staff needed to judge the validity of claimed fair-value amounts. The reality of this situation is demonstrated by Deloitte’s 2007 sale of its property tax practice.
Under some circumstances, changes in PPE fair-value amounts under international standards will influence re-ported income, which might prompt attempts at earnings management, for which auditors would need to be alert.
The fair value of utility PPE can be expected to be higher than original cost less accumulated depreciation, and so would increase the rate base and annual depreciation expenses of regulated entities. This situation likely either will prompt rejection for ratemaking purposes or, as has been done by jurisdictions required to consider PPE values reflecting something other than original cost, prompt consideration in a manner that doesn’t influence authorized prices. Therefore, even though a regulated entity might opt to report fair value, regulation likely would continue to be based on original cost, which would require maintaining both original-cost and fair-value records. Maintaining multiple sets of records, however, is