In the early days of what is now modern, authoritative GAAP, paras. 46–52 of Accounting Terminology Bulletin 1, Review and Résumé, issued by the AICPA in 1953, engaged in a scholarly debate as to what the term “depreciation” means—whether it recognizes an estimate that imprecisely measures the diminution of value of an asset over time or an allocation of its historical cost. This is no longer debatable, as it remains clear in the literature that the latter is the case, assuming use of the cost basis of accounting.
FASB currently emphasizes that depreciation accounting “is a process of allocation, not of valuation” and describes it as the expense that results from the systematic and rational allocation of the cost of a productive facility or other tangible capital asset, less salvage (if any), as equitably as possible to the periods during which services are obtained from the use of the asset (i.e., its “useful life”) [Accounting Standards Codification (ASC) 360-10-35-4]. Although it is not generally well-known or observed in practice, GAAP also provides that the depreciation method should be selected and supportable based upon management’s judgment as to what will likely provide the most satisfactory allocation of cost, considering whether “the expected productivity or revenue-earning power of the asset is relatively greater during the earlier years of its life” (ASC 360-10-35-7).
In 1971, the AICPA’s Accounting Principles Board (APBO) issued Opinion 20, Accounting Changes, para. 10 of which asserted that the service lives and salvage values of depreciable assets are in fact examples of accounting estimates that may require adjustments from time to time based upon an assessment of changing circumstances and the exercise of judgment by management “as more experience is acquired, or as additional information is obtained.” Paras. 31–33 prescribed accounting and disclosure guidance as to material changes in such estimates.
When APBO 20 was superseded in 2005 by FASB’s Statement of Financial Accounting Standards (SFAS) 154, Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3, the foregoing principles and requirements remained embedded without substantive change in the general definition of a change in accounting estimate, with the accounting for such estimates prescribed by paras. 19–20 of APBO 20 (ASC 250-10-45-17, 18). Meanwhile, the need to reconsider the estimated remaining useful lives and salvage values of depreciable assets, particularly in connection with periodic impairment assessments, was reinforced in paras. 9 and 28 of SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (ASC 360-10-35-22). Despite the presence of material impairment adjustments in many financial statements, however, there is rarely any mention of a concurrent shortening of the impaired asset’s estimated useful life for purposes of accelerating future depreciation charges.
Note that the term “service lives” was carried forward from APBO 20 into SFAS 154 and continues to appear in FASB. Alternate terms, however, are used in various places throughout subsequently issued standards, with “useful lives” being the term most commonly used in practice. “Useful lives” is defined in the Master Glossary as “the period over which an asset is expected to contribute directly or indirectly to future cash flows.”
APBO 20 also prescribed certain disclosures about the use of estimates in financial accounting in general, but such disclosures only rose to the forefront in 1994 with the Accounting Standards Executive Committee’s (AcSEC) issuance of Statement of Position (SOP) 94-6, Disclosure of Certain Significant Risks and Uncertainties (ASC 275). Among the additional disclosures about the use of estimates in the financial statements required by ASC 275-10-50-4 through -15A is whether it is reasonably possible that a change in an accounting estimate may materially affect the financial statements in the near term (i.e., one year).
What Actually Happens in Practice?
Most management teams typically fail to invest either time or attention into making or periodically revisiting and revising reasonably supportable estimates of asset lives or salvage values, or the selection of depreciation methods, as prescribed by GAAP. Rather, they tend to shortcut these estimates, usually basing them on published IRS guidelines (perhaps for the purpose of avoiding tedious deferred income tax calculations) and therefore often over-or underdepreciating assets. Accordingly, most reported gains or losses on the disposition of depreciable property assets seen in financial statements appear to this author to be the result of using arbitrary depreciation lives that are not true “best estimates” and are not properly reevaluated and adjusted periodically.
For example, the IRS tables provide for a five-year life on computer equipment, which generally tends to become obsolete and require replacement in three years or less. Buildings, on the other hand, tend to remain in service far in excess of the IRS-prescribed depreciation lives. Note that as far back as 1963, APBO 1, New Depreciation Guidelines and Rules, cautioned taxpayers to “carefully review the estimates of useful life of depreciable property adopted for financial accounting purposes … conforming them with [IRS] Guideline lives [only] to the extent that the latter fall within a reasonable range of estimated useful lives applicable in his business.”
Depreciating an asset over a life that is less than its properly estimated probable service life results in excessive charges to operations and fully depreciated assets that are still in use, both of which are inconsistent with the conceptual purpose of depreciation accounting. Depreciating an asset over a life that exceeds its properly estimated probable service life produces an automatic and mechanical salvage value, as does use of a declining balance method of depreciation. While this is acceptable, a deliberately estimated provision for salvage values is almost never factored into depreciation calculations, as a literal, conceptually faithful interpretation of GAAP would require. Moreover, a possible future change in the estimated useful life or salvage value of a productive asset is rarely mentioned among the mandatory disclosures about possible near-term revisions to accounting estimates. Sometimes an asset’s net carrying value has been written down by an impairment adjustment but is unaccompanied by an appropriate acceleration of the depreciation rate, setting the stage for another probable impairment adjustment or an inappropriate future disposal loss.
The effects of these shortcuts are often seen in the financial statements in the carrying of fully depreciated productive assets that are nevertheless still in use, and therefore overdepreciated, followed by improper recognition of disposal gains or losses. In addition, financial statements frequently include fully depreciated assets that are no longer in use and consequently should have been removed from the accounts. These common practices are consistent with neither the depreciation example presented in APBO 20 nor FASB’s definition of depreciation paraphrased above. The requirements, deeply embedded in GAAP, to invest intelligent energy in these depreciation-related estimates and any necessary periodic changes therein are largely overlooked by financial statement preparers and their accountants and auditors.
This author acknowledges that the SEC’s Staff Accounting Bulletin (SAB) Topic 5B, Gain or Loss from Disposition of Equipment, issued in the mid-1970s as SAB 1, sets forth the SEC staff’s views, in part, as follows: “Gains and losses resulting from the disposition of revenue-producing equipment should not be treated as adjustments to the provision for depreciation in the year of disposition, but should be shown as a separate item in the statement of income.”
In this author’s opinion, however, the SEC staff did not give proper consideration to the above-discussed provisions of paras. 10 and 31–33 of APBO 20, which had only recently been issued at the time. This author thus believes that the SEC staff’s conclusion in SAB Topic 5B is not only ill-conceived and consequently oversimplified, but it is also conceptually unsound and inconsistent with and unsupported by GAAP. Therefore, SAB Topic 5B should be rescinded or appropriately corrected consistent with this analysis.
How Should Asset Disposal Gains and Losses Be Treated?
GAAP departures that result from insufficient management attention to determining or updating estimates of useful lives are frequently immaterial. In such cases, treating disposal gains and losses as current period depreciation adjustments (in spite of the SEC’s position) is a practical and reasonable financial reporting approach. Due to immateriality, disclosures that are typically required in connection with estimate changes would be unnecessary in such instances. Any material gains and losses under consideration for reporting, however, should be closely analyzed to determine if they are either the result of 1) improper estimates that were biased or not based upon reasonable assumptions and the best information available at the time they were made or last adjusted (and therefore constitute errors, the correction of which require presentation under GAAP as prior period adjustments pursuant to ASC 250-10-45-24) or 2) current changes in estimated lives or salvage values attributable to changes in circumstances that should be accounted for either currently or prospectively as a change in estimate, with all required disclosures, pursuant to ASC 250-10-45-17 and 250-1050-4.
When gains or losses from disaster recovery result from insurance benefits that vary materially from the damaged asset’s properly depreciated carrying value, particularly when based on replacement cost, they are generally characterized as insurance (or fire and flood) gains or losses rather than asset disposal gains or losses.
After making any adjustments indicated by such a diligent analysis as described above, any remaining material credits or charges to be reported as disposal gains or losses (as prescribed for SEC issuers by SAB Topic 5B) should ordinarily be limited to those that result from true economic asset appreciation or diminution in value or from identifiable events that suddenly cause asset impairment and could not have been foreseen in the estimation process. The Exhibit illustrates the thought process involved in the above analysis.
For example, consider an item of equipment purchased for $100,000 and depreciated using the straight-line method over a useful life estimated by management at the time of purchase to be 10 years with no salvage value. During the sixth year, management decides that, due to new technological developments, it will likely replace and dispose of the item by the end of the eighth year, also with no significant salvage value. Therefore, the estimated useful life of the equipment should be shortened to eight years, and the undepreciated cost should be depreciated prospectively over the remaining two years of useful life pursuant to ASC 250-10-45-17, with appropriate disclosures if material per ASC 250-10-50-4. (This example presumes no change in the depreciation method and that the cost of the equipment will be fully recovered through revenue-earning activity over the shorter life, so that no impairment adjustment is warranted.)
Any material gains and losses under consideration for reporting should be closely analyzed to determine if they are either the result of improper estimates or current changes in estimated lives or salvage values.
If management fails to make the foregoing change in estimate adjustment at the end of the sixth year and again after the seventh, then 20% of the original cost, or $20,000, will remain undepreciated at the time of disposal, which management will write off and record as a loss. If the $20,000 is material, however, the conceptually correct accounting at disposal would be to retroactively spread it over the previous two years as a prior-period adjustment (i.e., an error correction) as prescribed by ASC 250-10-45-22–24. Accordingly, there should be no disposal loss presented under either scenario.
On the other hand, if management has no way of knowing in advance that disposal of the asset by the end of the eighth year would likely be judged beneficial and probable, the original estimated useful life would remain supportable by reasonable assumptions and all available relevant information. If an announcement were made after eight years of new technology that caused the item to become obsolete, reporting a $20,000 disposal loss (possibly characterized as an impairment loss) would be appropriate.
Financial statement preparers, as well as their accountants and auditors, should pay more attention to the quality of depreciation-related estimates and their possible mischaracterization and losses of credits and charges to operations as disposal gains.