Accumulated provisions for depreciation belong on the right side of the balance sheet.
John Ferguson, CDP, formerly was a principal with Deloitte & Touche, and now chairs the current issues committee of the Society of Depreciation Professionals. This article reflects the views of the author and not Deloitte or the Society. Email him at email@example.com.
Until the late 1940s, the accepted accounting convention was to locate the accumulated provision for depreciation on the right (liability and capital) side of the balance sheet. The convention since has been to locate it on the left (asset) side as a contra-asset. This change was controversial, and has led to some strange accounting for the expenditures incurred to remove or abandon in place property, plant, and equipment (PP&E) at the end of its useful life (referred to here as removal costs or expenditures).
Recent events suggest now is an opportune time to revisit where the accumulated provision belongs. For example, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board are working to harmonize their respective standards. The Securities and Exchange Commission (SEC) announced its intention to allow financial reporting based on international accounting standards without reconciliation to U.S. generally accepted accounting principles (GAAP). And the SEC’s advisory committee on improvements to financial reporting recommended that accounting rules avoid special treatment for specific industries. Finally, financial accounting has moved away from emphasizing the concept of matching to emphasizing fair value.
In this context, accounting practices might be poised for a change, putting accumulated provisions for depreciation back on the right side of the balance sheet.
Allocation, Not Valuation
The balance sheet location controversy didn’t cease with moving the accumulated provision to the left side. For instance, a January 1959 Accounting Review article suggested that the location change be revisited. 1 In the article, a random sample of the then-recent annual reports of 90 industrials and railroads and 10 utilities showed one industrial, one railroad and three utilities continuing to report the accumulated provision on the right side, rather than as a contra-asset on the left side. Right-side treatment by utilities is not surprising, because utilities objected to the change 50 years ago.
Depreciation accounting is a cost-allocation concept—not a valuation concept—and an objection to left-side treatment was that it can lead some to incorrectly interpret the resulting net asset amount as being the current value of the assets. An objection to right-side treatment was that the accumulated provision is not a liability, so does not belong on the right side. The accumulated provision obviously isn’t a liability, but it is a source of funds, and sources of capital are recorded on the right side. The removal or abandonment obligation clearly is a liability. However, the liability is the estimated expenditure measured at the price level expected at the time of expenditure, not the amount of the estimated expenditure already recorded as an expense and charged by regulated enterprises to their ratepayers.
For enterprises subject to price regulation, the accumulated provision clearly is a source of funds because rate-base regulation treats the accumulated provision as being ratepayer-supplied capital, for which a credit is provided at the allowed cost of capital. Recognizing depreciation as a source of funds also is evident from the U.S. government allowing income-tax depreciation to be accelerated in order to provide funds (tax savings) for business expansion. This view was reinforced when the initial attempts by price regulators to pass the tax savings on to ratepayers prompted the IRS to deny accelerated tax depreciation to entities not allowed to retain the resulting tax savings.
Being recorded as a contra-asset has led to concern that net asset amounts could become negative, which has led to some strange accounting for expenditures for removing or abandoning PP&E. For long-lived assets, salvage usually is inconsequential, and removal expenditures frequently exceed the historical cost of the related assets. Therefore, accurately recognizing these expenditures for accounting purposes is at least as important, if not more important, than is recognizing the consumption of the related PP&E when providing a product or service. However, accounting practices don’t recognize this importance.
Regulatory agencies were well ahead of the accounting profession in recognizing that the concept of retirement accounting made no sense, and so adopted depreciation accounting. Under retirement accounting, investment is recorded as an expense upon retirement, salvage is recorded as income when received, and removal cost is recorded as an expense when incurred. Regulators also were ahead in recognizing there are three components to depreciation—investment, salvage, and removal expenditures—and that accurately charging these costs to ratepayers necessitates recording them ratably over the useful life of the related PP&E.
This recognition means a known investment cost is accrued (recorded as a periodic expense) after being incurred, an estimated future salvage amount is accrued (recorded as a periodic credit) before being received, and an estimated future removal expenditure is accrued (recorded as a periodic expense) before being spent. This treatment assures that ratepayers are charged no more and no less than the costs being incurred to serve them, at the time the service is rendered and the costs are incurred—which is known as the regulatory principle of intergenerational ratepayer equity.
Regulatory depreciation accounting rules are more detailed than are financial accounting rules, and are specified by the Uniform Systems of Accounts (US-ofAs) prescribed by FERC and other entities. Almost all USofAs dictate that salvage and removal costs be treated as components of depreciation, 2 and this treatment predates World War I. The basic foundation for the regulatory accounting treatment of salvage and removal cost is evident from the FERC USofAs for electric utilities and natural gas companies, which define depreciation as “loss in service value,” define service value as “the difference between original cost and net salvage value,” and define net salvage value as “the salvage value of property retired less the cost of removal.”
Salvage vs. Net Salvage
It took a while, but the U.S. accounting profession eventually caught up with the regulators, evident from the definition of depreciation given in a sidebar that was issued during the 1950s. Three aspects of this definition are significant to the treatment of removal costs—the requirement to be systematic and rational, consideration of salvage, and recognition that depreciation accounting is a process of allocation, not of valuation.
The rational aspect of “systematic and rational” means that depreciation is to be recorded in a manner that matches the pattern of usage or revenue-generating capability of the related assets, consistent with the regulatory principle of intergenerational ratepayer equity. Thus, if the asset usage or revenue pattern is decreasing, the depreciation method should be accelerated relative to the life span of the asset. If the pattern is constant, depreciation should be constant relative to the life span, and if the pattern is increasing, depreciation should be deferred relative to the life span.
The PP&E of regulated entities exhibits decreasing or constant patterns over their lifetimes—not increasing patterns. Therefore, U.S. GAAP dictates that the depreciation rates of such entities (and probably of all entities) be constant (ratable) over life defined by either time or asset usage.
The U.S. GAAP definition reference to salvage is intended to mean “net salvage,” thereby encompassing removal costs. If the definition had been meant to incorporate only salvage into depreciation, it would have stated “gross salvage” rather than merely “salvage.” This terminology has proven to be unfortunate, because it has created confusion concerning how removal costs are to be dealt with for accounting purposes. As a result, the true intention of the GAAP definition has been lost, and strange accounting has occurred.
Several facts support the “net salvage” definition of “salvage” within GAAP. At the time of the definition, the term “salvage” generally was used to mean “net salvage” (i.e., salvage proceeds less removal expenditures), and utilities typically incorporated removal costs into depreciation for regulatory accounting purposes. Additionally, the “net salvage” definition supports greater consistency in treating different end-of-life transactions (salvage and removal costs) ratably through depreciation. Treating removal costs differently from investment and salvage conflicts with the premise that accounting practices should be reliable and relevant.
The ratable treatment of removal costs through depreciation for regulatory accounting purposes has a long history, but periodically is challenged by proposals to defer recording and recovery. Such challenges also have a long history, but have taken on renewed vigor as a consequence of FASB Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations, (SFAS 143), issued in 2001.
Challenges to ratable treatment of removal costs for regulatory purposes are unfortunate, because they lead to proposals for deferral mechanisms that, if accepted by regulators, increase the costs to be borne by ratepayers over the life of the related PP&E, thereby increasing energy costs and damaging the competitiveness of the state 3(see “Depreciation Shell Game,” Fortnightly, April 2008).
Removal cost deferrals result from regulatory decisions that emphasize near-term political considerations over long-term economic considerations. The financial community and large energy users can be expected to interpret such regulatory unfairness as signaling deterioration of the business climate. The financial community might react to such a signal by downgrading the securities of jurisdictional entities and of the state itself. Additionally, large energy users typically work from multiple locations, so they can shift production between locations in reaction to regulatory decisions—and sometimes they do. Large energy users participating in regulatory proceedings typically emphasize long-term considerations, through addressing cost-allocation (equity) issues, rather than issues concerning the magnitude of cost of service. It’s not unusual for such users to react to a business-climate deterioration signal by shifting from emphasizing equity to emphasizing the near-term cost-of-service magnitude in their participation in regulatory proceedings.
SFAS 143 is an example of the movement away from emphasizing matching to emphasizing fair value. It segregates retirement obligations (removal expenditures) imposed by law, statute, regulation or contract (legal obligations) from depreciation, and specifies that such obligations be recorded as liabilities—not as depreciation. The specified treatment is to record the initial discounted amount of the expected expenditure as part of the depreciable cost of the related asset and as an initial liability, and to record future accretion—due to the discounting unwinding over time—as accretion expense. This treatment is a single-payment (prepaid) annuity, but is recorded in a manner that gives it a structure similar to a multiple-payment annuity—the typical form of sinking-fund depreciation.
SFAS 92, Regulated Enterprises—Accounting for Phase-in Plans, defines annuity methods of depreciation as phase-in plans that are precluded from use for either regulatory or financial accounting purposes, unless the practice was regulatory policy prior to 1982. SFAS 143 side steps this limitation by classifying legal obligations as liabilities, so the specified treatment is not required to be “rational.” Also, SFAS 92 is interpreted as applying only to investment, which is another consequence of the accumulated provision being on the left side of the balance sheet.
The deferral inherent in SFAS 143 treatment is evident in the obligation for decommissioning a nuclear generating unit, which is the obligation that prompted issuance of SFAS 143. A nuclear unit that receives a renewed operating license from the Nuclear Regulatory Commission is likely to have an operating life span of about 55 years. If decommissioning occurs 10 years after operations cease and the SFAS 143 discount rate is 8 percent, then 99.3 percent of the obligation would be recorded as accretion over 65 years, with the accretion amount recorded during the final year being 137 times the amount recorded during the first year, and 54 percent of the total accretion being recorded after the unit ceases to operate and generate revenues—and, for a single-asset entity, after the enterprise ceases to be viable. This is really strange accounting.
The exposure draft of what eventually became SFAS 143 called for liability treatment of both legal and constructive obligations, which is the same as for international standards. However, SFAS 143 was limited to only legal obligations when FASB concluded that constructive obligations could not be defined tightly enough for consistent application, which suggests the international standard is not consistently being applied.
Limiting SFAS 143 to legal obligations did not preclude inconsistent application, and the FASB felt the need for clarification through issuing FASB Interpretation 47, Accounting for Conditional Asset Retirement Obligations, (FIN 47) in 2005. FIN 47 improved the consistency of reporting, but did not eliminate the problem—which is due, in part, to the difficulty in applying SFAS 143 by entities practicing the group concept of depreciation accounting. However, the remaining inconsistency pales when compared to the inconsistency resulting from the misinterpretation of the GAAP definition of depreciation accounting.
This misinterpretation means that regulated entities record removal or abandonment obligations ratably over the life of the related PP&E, except for a few that are subject to the jurisdiction of regulatory agencies that have imposed deferral mechanisms. At the same time, non-regulated entities record such obligations using one of two deferral mechanisms—SFAS 143 treatment for legal obligations, and cash treatment for other obligations. Entities practicing the item concept of depreciation accounting record and depreciate each item of PP&E separately, so related legal removal obligations easily are identified, recorded and tracked. Entities practicing the group concept easily can identify, record, and track such obligations for PP&E recorded and depreciated by location, such as for power plants, but it is next to impossible to track such obligations for PP&E not so recorded and depreciated, such as for electric and gas distribution systems.
SFAS 71, Accounting for the Effects of Certain Types of Regulation, allows qualified entities to utilize accounting practices that cannot be utilized by non-qualifying entities. The effect of qualification is that the income statement reflects regulatory accounting requirements, with any differences from financial accounting requirements being disclosed on the balance sheet as regulatory assets or liabilities. For example, obligations qualifying for liability treatment under SFAS 143 typically are reflected in depreciation for ratemaking purposes, so depreciation treatment would be reflected on the income statement and a regulatory liability disclosed. Disclosing a regulatory liability means that regulated entities must maintain accounting records for both depreciation treatment and liability treatment of legal obligations. SFAS 71 would be rescinded, if the SEC follows the recommendation of its advisory committee to avoid special treatment for specific industries. Rescinding would be a problem for regulators, because the financial statements of regulated entities could no longer match removal costs to the usage of the PP&E providing service to ratepayers, thereby violating the principle of intergenerational ratepayer equity.
It wouldn’t be difficult to eliminate the strange removal cost accounting and the potential for violating the principle of intergenerational ratepayer equity. Doing so would allow financial statements to more accurately depict the financial position and results of operations of the reporting enterprises and ensure that ratepayers bear the costs being incurred to serve them. All that’s necessary is to recognize that the accumulated provision for depreciation is a source of funds that belongs on the right side of the balance sheet, and to change the reference to “salvage” in the GAAP definition of depreciation accounting to “net salvage.”
These two actions would allow FASB to rescind SFAS 143, and would promote consistency, comparability, reliability, and relevance by requiring all enterprises to use the same removal cost treatment for accounting purposes.
1. Simon, Sidney, “The Right Side of Accumulated Depreciation”Accounting Review, Rutgers University, January 1959.
2. The only exception to incorporating removal or abandonment costs in depreciation that the author is aware of is the railroad USofA of the Surface Transportation Board, and that exception is limited to PP&E other than the track structure accounts.
3. Detrimental impacts easily are demonstrated, but are beyond the scope of this article.