Fair value accounting is not the right answer

Depreciation would be a joke if it weren't such a disgrace ... but that's precisely what happens when accountants calculate depreciation expense in advance and then report it on future income statements. There is no valid justification for reporting assumed depreciation instead of actual observed amounts (including appreciation)."

Thus spoke Miller and Bahnson in the Oct. 25-Nov. 7, 2004, issue of Accounting Today (page 14). While the eminent professors probably know this, let's recap the fundamentals of depreciation, as shown in the authoritative Wiley GAAP Guide.

The definition of depreciation is given as: "The periodic charge to income that results from a systematic and rational allocation of cost over the life of the asset."

The GAAP Guide goes on to explain: "The costs of fixed assets (less residual or salvage value) are allocated to the periods they benefit through depreciation ... the determination of useful life must take a number of factors into consideration, including technological change, normal deterioration, and actual physical usage. The method of depreciation is determined as a function of time (e.g., technological change or normal deterioration) or as a function of actual physical usage."

Miller and Bahnson cannot be against "systematic and rational," and they must support the idea of matching expense and revenue. Their criticism actually boils down to a plea for fair value accounting of property, plant and equipment, as contrasted with the current generally accepted historical cost method of accounting. Even the Financial Accounting Standards Board, dedicated to the proposition that fair value is a superior concept, has not seriously gone down the path of reporting fair values for PP&E. But that FASB fears to tread here obviously has not stopped the distinguished professors.

While we have commented in general terms on the impracticality of fair value accounting in previous articles, it is time to specifically hit head-on the topic of PP&E and related depreciation. The writer has spent the last 35 years dealing professionally with this exact issue, and has dealt with numerous valuation and depreciation issues related to PP&E in the course of valuing over $100 billion of total asset values.

Been there, done that

While it was undoubtedly before their time, a brief review of the history books would have shown them that both the Securities and Exchange Commission and FASB have already attempted to deal with current values of PP&E - and failed! In fact, they both failed miserably.

In the late 1970s, inflation was rampant. Both the SEC and FASB felt that current historical cost depreciation, based on original asset acquisition cost, was understating expense and overstating income. The explicit assumption was that if companies had to buy the equipment in use today, the then-current prices would be higher, the depreciation on that higher cost greater, and income would be reduced. In short, they felt that historical cost was misleading and, to use Miller and Bahnson's terminology, "there [was] no valid justification for reporting assumed depreciation [based on original cost] and that [it did not] provide useful information for decisions."

A funny thing happened to both versions of inflation accounting. They did not work! They were not used by analysts or shareholders! Both versions of inflation accounting were quickly repealed! And, most fortuitously, this has been forgotten by the professors.

Why did both the FASB and SEC pronouncements fail? They each tried to create a false reality. In short, they were each a manifestation of what I call "'what if' accounting."

While the SEC wanted companies to determine depreciation on the basis of what it would cost to replace the assets today, including technology changes, FASB wanted to apply price indices to original cost.

In both systems, current cost of assets was displayed, as well as the impact of higher (theoretical) depreciation charges based on that higher current cost or value. The answers were meaningless in terms of actual cash flows for replacement of assets, and analysts learned nothing about the future cash flows that companies would actually incur. Why?

Simply, current depreciation charges, often based on lives determined for tax reporting, significantly understate the useful life of assets. The simplest examples are in real estate. Most companies depreciate buildings over 40 years. That means that any building built before 1964 should be fully depreciated and ready for the wrecking ball - that is, if current depreciation charges truly reflect useful life. Obviously, most buildings last for way more than 40 years. So coming up with a replacement cost of the building - either by using today's construction costs, or by indexing the original cost by a construction cost index - tells us nothing about actual or even potential cash outflows.

Similarly, machinery and equipment have far longer useful lives than are contemplated by the typical corporate depreciation schedule. Go through any manufacturing facility, and ask the general manager when items were acquired. Other than in the high-tech area, many, if not most, will have been acquired more than 15 years ago - thus demonstrating once again the futility of trying to come up with the cost of replicating facilities that are not going to be replicated.

The objective of financial reporting

If anyone should be familiar with the "Objectives of Financial Reporting," as set forth in FASB Concepts Statements, it should be the professors. Perhaps they forgot, but one of the primary objectives is to help shareholders and creditors to understand future cash flows to the enterprise.

Neither FASB's current cost nor the SEC's replacement cost theories provided any useful information in meeting this objective. The truth is that companies rarely retire an asset and buy a similar asset. Rather, they maintain the old asset for an indefinite period.

When it does come time to buy new assets, based on some current-cost-of-capital calculations, the answer is a function of the sales possibilities for new products and services, or the reduction of existing labor costs. Neither of these types of capital expenditures (which do involve cash flows) was captured by the SEC and FASB approaches.

Messrs. Bahnson and Miller have not laid out a detailed methodology for their fair value of existing PP&E. Nor have they indicated how such information would meet the test of helping shareholders and creditors understand future cash flows. Until they can accomplish this, we suggest that they accept that historical cost depreciation, while not perfect, does provide a good approximation of the loss in utility of existing PP&E.

Going to a theoretical fair value model will cost those shareholders and creditors a lot of the resources of the companies they have invested in. Appraisers would have to be hired. Their auditors would have to review the calculations. The SEC would monitor the exercise and the Public Company Accounting Oversight Board would undoubtedly get involved.

Do shareholders - and I do not refer to corporate management at this point - really want costs to be incurred to provide theoretical information with zero or perhaps even negative value? This author thinks the status quo, while not perfect, is superior to any proposals yet put forth.

Alfred M. King

Vice chairman

Marshall & Stevens

alfredking erols.com