The Securities and Exchange Commission (SEC) is taking steps toward substituting International Financial Reporting Standards (IFRS) for U.S. Generally Accepted Accounting Principles (GAAP). The most recent is publication last November for public comment of a proposed substitution process that the SEC refers to as a “roadmap.” Having certainty surrounding existing utility asset and depreciation accounting practices enhances the ability to use financial statements to accurately depict the results of operations and financial status of reporting entities.
These practices deserve to survive such a substitution, as they are consistent with the SEC’s roadmap statement that “it is important that the accounting standards produced are capable of improving the accuracy and effectiveness of financial reporting and the protection of inves-tors” (Nov. 14, 2008 SEC Release No. 33-8982, p. 23). If these practices don’t survive, regulators, their jurisdictional entities, and the investors in these entities might find the changes disturbing, and the SEC will not have accomplished its intended purpose.
A significant aspect of the potential for changes to utility accounting practices from this substitution is the recent recommendation by the SEC’s Advisory Committee on Improvements to Financial Reporting that accounting guidance not allow industry-specific exceptions. An example of the industry-specific guidance the Committee has in mind is SFAS 71, Accounting for the Effects of Certain Types of Regulation, that allows qualifying entities to utilize accounting practices not available to non-qualifying entities. Qualification requires that prices for service be set by an independent body or its governing board, be based on cost, and be charged to, and collected from, ratepayers, which limits SFAS 71 to being applicable to price-regulated entities. SFAS 71 is important because it is what allows the accuracy-enhancing accounting practices referred to above, and international standards contain no equivalent. However, last December the International Accounting Standards Board decided to add a project to its agenda that is intended to result in an accounting standard similar to SFAS 71, which marks a substantive departure from its practice of providing only transaction-specific guidance.
U.S. GAAP is recognized as being rules-based, but this wasn’t always the case, because it shifted from being principles-based as a consequence of the principles not being defined tightly enough for courts to determine whether entities were complying with them. Tightening the definitions resulted in rules. International standards are perceived as being principles-based, but are shifting toward being rules-based as a consequence of rules being issued in the form of interpretations. Principles are recognized as allowing more flexibility than do rules, which makes the judgments behind accounting-treatment decisions quite important. The SEC’s advisory committee recognizes the importance of accounting and audit judgments, and has recommended that the SEC and the Public Company Accounting Oversight Board adopt policy statements concerning the exercise of these judgments, 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.
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 cumbersome and a waste of resources.
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 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 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 substituted for U.S. GAAP. If these actions cannot be taken for international standards, the substitution should be rejected.