Do You Understand the Concepts Behind Depreciation?
Accountants and those who have taken accounting courses ususally understand the basics of depreciation. The basic concept is one of allocating the cost of long-lived depreciable assets (original cost, less net salvage value) through recording depreciation expenses in the periods of time that are benefitted by the costs of property, plant and equipment. Many people have heard of depreciation methods like the straight-line method, sum-of-years digits method, and the declining balance methods. Still a large group, but probably fewer people, know about tax depreciation methods that are specified in our tax laws, such as the Section 179 deduction, 50% bonus depreciation, and a variety of other accelerated and straight-line methods.
Depreciation – An Art (or Science) More Refined for Capital Intensive Industries
The Society of Depreciation Professionals is a major professional organization that fosters the teaching of the concepts of depreciation for capital intensive industries and the licensing of experts in the field of depreciation. People people who pass its rigorous professional licensing test are known as Certified Depreciation Professionals.
The reason that special expertise is required for depreciation professionals reflects the nature of the forces that cause retirements of long-lived depreciable assets as described by studies performed beginning in the 1920s and 1930s at Iowa State College. The result of these studies was a system of 22 “Iowa Curves” (statistical models) that describe the percent of depreciable assets surviviving at any point in time during the assets’ service lives and the probable average service lives of depreciable property. The Curves are classified into four groups (L, S, R and O curves) by three variables: the average life of the property, the location of the mode of the retirements, and the variation in the life of the retirements. (See the book, Depreciation Systems, by Wolf and Fitch published by Iowa State University Press, 1994.) These generalized curves, with the use of appropriate software and judgment, are used today by depreciation professionals serving the utility and other capital intensive industries as an aid to developing appropriate depreciation rates. Many factors enter into establishing appropriate depreciation rates such as the forces behind retirements (wear and tear, economic obsolescense, technological obsolescense, actions of governments, management actions, acts of God, etc.), the net cost of interim retirements of property (cost of removal and salvage value), and depreciation expenses already recorded. Basically, the curves are used to estimate the depreciable costs as they change over time that the depreciation rates will be applied against.
Why Are Depreciation Studies Important?
Depreciation studies are required to establish appropriate depreciation rates under public utility regulation, such as by the Federal Energy Regulatory Commission (“FERC”)and state regulatory commissions. In addition, depreciation rates affect income taxes, property taxes and the recorded net book value, or shareholders’ equity, of each capital intensive company. Certainly, prudent managements are interested in the probable lives of their productive assets. The answer to the probable life question is critical to capital budgeting decisions. The rapidity of change in our economy today makes periodic depreciation studies especially critical, since poor depreciation forecasts cost real money through the potential for overpayment of taxes and the possibility of underrecovery of the cost of service of regulated enterprises. The public at large also has a vested interested in these depreciation studies because they are a key element underlying the prices everyone pays for public utiltiy services.
Forecasting the Cost of Terminal Retirement
You may have heard the terminology “net negative salvage” or “asset retirement obligation”. Depreciation studies are not complete unless they provide for the allocation of costs related to the final retirement of long-lived facilities to the periods of time benefitted by the facilities. A major difficulty with this topic is the complexity of forecasting a future retirement cost and allocating that cost to current accounting periods. The Financial Accounting Standards Board and the FERC have both recognized the importance of dealing with these costs. A partial discussion of this topic is available at the www.bwmq.com web site in an asset retirement obligation article.