Issue (INT1030_09-04_COMPdec13_01-14)

With the adoption of accrual accounting by local, state, territory and Commonwealth governments, there has been increased interest in methods of depreciation of long-lived physical assets, including those assets described as ‘infrastructure’ assets or an infrastructure system (hereafter, the term ‘infrastructure assets’ is used to encompass infrastructure assets and infrastructure systems).  This interest has intensified with the increased privatisation of public sector activities and the increased application of ‘user-pays’ and ‘purchaser-provider’ models of service delivery for public sector entities.

Many of the activities of local, state, territory and Commonwealth government entities are capital intensive.  For example, there is significant investment in the physical assets that comprise the infrastructure necessary to support the services provided by state, territory and local government road, footpath and sewerage networks; public transport systems; and water storage and distribution systems.  Many private sector business entities and public sector trading enterprises also invest heavily in the physical infrastructure necessary to enable them to continue to produce the goods and services they sell.  For these public and private sector entities, the depreciation charge is a major expense item, and in some cases the single major expense item.

Accounting Standard AASB 116 Property, Plant and Equipment requires the depreciable amount of an asset to be allocated on a systematic basis over the asset’s useful life.  Some commentators argue that depreciation methods that have conventionally been adopted in respect of long-lived physical assets, including infrastructure assets, are not appropriate for such assets, particularly when they are controlled by public sector entities, because, for example:

(a)      these assets have very long useful lives, are often ‘complex’ assets comprising a number of components and are constantly rehabilitated during the course of their lives, so that it is often not possible to develop a reliable estimate of their useful life;

(b)     variations in estimates of useful life, rate of consumption of future economic benefits (or service potential) or residual value will have a major impact on the operating result of the entity;

(c)      in practice, it is not possible to distinguish between maintenance expenditure and expenditure to enhance the future economic benefits of the asset, so that maintenance and depreciation expenses cannot be reliably determined; and

(d)     the information required to implement these depreciation methods does not ‘fit’ with the information necessary for asset management purposes.

In response to these concerns, some public sector entities have adopted, or are considering the adoption of, alternative approaches to the depreciation of long-lived physical assets.  These alternative methods are often described as Condition-Based Depreciation (CBD) methods.  While CBD methods may vary in detail, they usually require the condition of the asset to be assessed periodically, often on an annual basis.  The cost of restoring the asset from its current condition to a predetermined service level is then estimated and any increase in the restoration cost beyond that estimated in the prior reporting period is recognised as depreciation expense.  In addition, all expenditures made in respect of the maintenance and refurbishment of the asset are recognised as an expense in the period in which they are incurred.

In many cases, CBD methods are linked to a detailed asset management plan incorporating the estimated maintenance, refurbishment and rehabilitation work required to maintain current or required service levels of the asset over the long term, often 20 years or more.  Under some CBD methods, the estimated costs of maintaining the asset over this period are converted to an annual annuity.  The annuity is compared with the actual maintenance, refurbishment and rehabilitation expenditures incurred during the reporting period and any shortfall between the amount of the annuity and the expenditure incurred in the period is identified as the depreciation expense because the shortfall represents a deterioration in the service level of the asset.  This depreciation expense, together with the maintenance, refurbishment and rehabilitation expenditures incurred during the reporting period, is recognised in profit or loss as an expense.

Adoption of CBD or similar methods of depreciation can have a significant impact on the operating results of public and private sector entities.  Differing views are held about the extent to which all, or some, CBD methods comply with the requirements of AASB 116.  Concern has been expressed that, in the absence of specific authoritative guidance, diverse, and potentially inappropriate, practices may develop and/or become entrenched.  Some commentators note that whatever the benefits of CBD and similar methods for asset management, cost projection, cash flow budgeting and pricing purposes, for financial reporting purposes the depreciation method adopted by an entity must comply with the requirements of AASB 116.

The issue is what, if any, characteristics of CBD and similar methods of depreciation contravene the requirements of Accounting Standards?