OVERVIEW OF A DEPRECIATION STUDY
GENERAL APPROACH TO DEPRECIATION STUDIES
The goal or objective of depreciation accounting—which is derived from cost allocation and accounting theory—is cost allocation over the economic life of an asset in proportion to the consumption of service potential. Achievement of this dual accounting objective is obtained by conducting periodic depreciation studies and adjusting depreciation rates to reflect current and future operating conditions.
The principle activities undertaken in conducting a depreciation study can be grouped into five major tasks:
- Data Collection;
- Life Analysis and Estimation;
- Net Salvage Analysis;
- Depreciation Reserve Analysis; and
- Development of Accrual
The minimum database required to conduct a statistical life study consists of a history of vintage year additions and unaged activity year retirements. These data must be appropriately adjusted to recognize transfers, sales and other plant activities that would otherwise bias the measured service life of normal retirements. The age distribution of surviving plant for unaged data can be estimated by distributing the plant in service at the beginning of the study year to prior vintages in proportion to the theoretical amount surviving from a survivor curve identified in the life study. The statistical methods of life analysis used to examine unaged plant data are known as semi-actuarial techniques.
A far more extensive database is needed to apply the statistical methods of life analysis known as actuarial techniques. The plant data used in an actuarial life study most often includes the age distribution of surviving plant at the beginning of the study year and the vintage year, activity year, and dollar amounts associated with normal retirements, reimbursed retirements, sales, abnormal retirements, transfers, corrections, and extraordinary adjustments. An actuarial database may include the age distribution of surviving plant at the beginning of the earliest activity year rather than at the beginning of the study year. Plant additions, however, must be included in a database containing an opening age distribution to derive aged survivors at the beginning of the study year. The availability of this detailed information is dependent upon an accounting system that supports aged property records.
Life Analysis and Estimation
Life analysis and life estimation are terms used to describe a two-step procedure for estimating the mortality characteristics of a plant category. The first step (i.e., life analysis) is largely mechanical and is primarily concerned with history. Statistical techniques are used in this step to obtain a mathematical description of the forces of retirement acting upon a plant category and an estimate of its service life. The mathematical expressions used to describe these life characteristics are known as survival functions or survivor curves. The second step (i.e., life estimation) is concerned with predicting the expected remaining life of property units still exposed to the forces of retirement. It is a process of blending the results of the life analysis with expectations about the future to obtain an appropriate projection life curve. The amount of weight given to the life analysis will depend upon the extent to which past retirement experience is considered descriptive of the future.
The analytical methods used in a life analysis are broadly classified as actuarial and semi-actuarial techniques. Actuarial techniques can be applied to plant accounting records that reveal the age of a plant asset at the time of its retirement from service. In other words, each property unit must be identifiable by date of installation and age at retirement. Semi- actuarial techniques can be used to derive service life and dispersion estimates when age identification of retirements is not readily available.
While actuarial and semi-actuarial statistical methods are well suited to an analysis of plant categories containing a large number of homogeneous units (e.g., meters or services), the concept of retirement dispersion is inappropriate for plant categories composed of major items of plant that will most likely be retired as a single unit. Plant retirements from an integrated system prior to the retirement of the entire facility are more properly viewed as interim retirements that will be replaced in order to maintain the integrity of the system. Additionally, plant facilities may be added to the existing system (i.e., interim additions) in order to expand or enhance its productive capacity without extending the service life of the present system. A proper depreciation rate can be developed for an integrated system using a life-span method.
The selection of life statistics that will adequately describe the expected remaining life of property units still exposed to the forces of retirement is a process of blending the results of an analysis of history with expectations about the future. A well-reasoned life estimate requires an understanding and recognition of the forces of mortality which caused retirements in the past and the forces of mortality that will most likely cause retirements in the future. A simple extrapolation of history will fail to describe the future to the extent that forces of retirement are changing or are predicted to be different from those observed in the past.
Net Salvage Analysis
An estimate of the net salvage rate applicable to future retirements is usually obtained from an analysis of gross salvage and removal expense realized in the past. An analysis of past experience (including an examination of trends over time) provides an appropriate starting point for estimating future salvage and cost of removal. However, consideration should also be given to events that may cause deviations from the net salvage realized in the past. Among the factors that should be considered are the age of plant retirements, the portion of retirements that will be reused, changes in the method of removing plant, the type of plant to be retired in the future, inflation expectations, the shape of the projection life curve, and economic conditions that may warrant greater or lesser weight to be given to the net salvage observed in the past.
Special consideration should also be given to the treatment of insurance proceeds and other forms of third-party reimbursements credited to the depreciation reserve. A properly conducted net salvage study will exclude such activity from the estimate of future parameters and include the activity in the computation of realized and average net salvage rates.
Depreciation Reserve Analysis
The purpose of a depreciation reserve analysis is to compare the current level of the recorded reserve with the level needed to achieve the goals and objectives of depreciation accounting if the amount and timing of future retirements and net salvage are realized exactly as predicted. The difference between the required depreciation reserve and the recorded reserve provides a measurement of the expected excess or shortfall that will remain in the depreciation reserve if corrective action is not taken to extinguish the reserve imbalance.
Although reserve records are typically maintained by various account classifications, the total reserve for a company is the most important measure of the status of the company’s depreciation practices and procedures. If a company has not previously conducted statistical life studies or considered retirement dispersion in setting depreciation rates, it is likely that some accounts will be over–depreciated and other accounts will be under–depreciated relative to a calculated theoretical reserve. Differences between the theoretical reserve and the recorded reserve also will arise as a normal occurrence when service lives, dispersion patterns and salvage estimates are adjusted in the course of depreciation reviews. It is appropriate, therefore, and consistent with group depreciation theory to periodically redistribute the total recorded reserve among the various primary accounts based upon the most recent estimates of retirement dispersion and net salvage rates.
Development of Accrual Rates
The goal or objective of depreciation accounting is cost allocation over the economic life of an asset in proportion to the consumption of the service potential. Ideally, the cost of an asset (which represents the cost of obtaining a bundle of service units) should be allocated to future periods of operation in proportion to the amount of service potential expended during an accounting interval. The service potential of an asset is the present value of the future net revenue (i.e., revenue less expenses exclusive of depreciation and other noncash expenses) or cash inflows attributable to the use of that asset alone.
Cost allocation in proportion to the consumption of service potential is often approximated by the use of depreciation methods that employ time rather than net revenue as the apportionment base. Using a time-based allocation method, however, does not alter the goal of depreciation accounting. If it is reasonable to predict that the net revenue pattern of an asset will either decrease or increase over time, then an accelerated or decelerated time- based method should be used to approximate the rate at which service capacity is actually consumed.
The time period over which the cost of an asset will be allocated is determined by the combination of a procedure and a technique. A depreciation procedure describes the level of grouping or subgrouping of assets within a plant category. The broad group, vintage group, equal-life group, and item or unit are a few of the more widely used procedures. A depreciation technique describes the life statistic used in a depreciation system. The whole life and remaining life (or expectancy) are the most common techniques.