LGFP Qld Annual Conference
– Appreciating Depreciation
QTC sustainable local government
depreciation framework
25 November 2014
Objective today is to discuss:
§  Emerging themes, commentary and responses
–  issues to consider
§  Depreciation – the accounting perspective
–  what is depreciation; what depreciation is not.
–  the QTC premise
§  Application of depreciation concepts
–  challenges: asset value, residual value, useful life
§  Strategies identified
–  some practical examples
2
Emerging themes
§  Financial performance
–  reported as declining
§  Financial and physical ‘sustainability’ indicators
–  interpreted as concerning
§  Asset valuation and depreciation of infrastructure assets
–  assessed as volatile
3
Emerging commentary
§  Financial performance
–  “The annual depreciation expense is too high”
§  Financial and physical ‘sustainability’ indicators
–  “The 3 ratios are poor measures of sustainability”
§  Asset valuation and depreciation of infrastructure assets
–  “ We are just following the accounting rules”
4
Emerging responses
§  “We are thinking of gaming the system to improve our financial
results”
§  “Let’s ignore the results until better sustainability measures are
adopted”
§  “Why don’t we change the accounting rules”?
§  “We are actually ok, everyone else has it wrong”
§  Why don’t we……..
5
However…prior to responding
Some questions to consider:
§  Is there clarity on the problem?
§  Is there an understanding as to the root cause(s)?
§  Has there been an assessment of the implications?
§  Has there been consideration of the options?
6
Financial accounting requirements
§  Physical assets are required to be recognised in the books of account
if it is probable that the future economic benefits (ie, usefulness)
embodied in the asset will eventuate, and
§  That the cost or value of the benefit is capable of being measured
§  The allocation of the physical asset’s cost (or value) is expensed over
the life of that asset - the accrual accounting concept of depreciation.
7
Depreciation expense - definition
Depreciation is the consuming or using up of the economic benefits
inherent in an asset over the asset’s useful life.
§  Accounting depreciation expense is the systematic allocation
of the depreciable amount of an asset over its useful life.
a)  Asset cost or value
b)  Estimated useful life and
c)  Estimated residual value
8
Clarifying the concept
§  The accounting rules have been designed to ensure that the asset’s
cost is more evenly matched to the revenue earned by (or benefits
being derived from) the asset.
§  The rules are predicated on the notion that depreciation of a physical
asset (with the exception of land) commences when the asset first
becomes available for use and ceases when a decision has been
made to dispose of or decommission it.
9
Accounting depreciation – what is it not?
Depreciation is not:
§  about funding a replacement asset at the end of its life.
Under the Australian Accounting Standards, it is not appropriate to consider the annual accounting
depreciation expense from a funding perspective.
§  about requiring the establishment of a cash backed fund.
–  Establishing a cash backed fund is entirely separate from the accounting
depreciation concept.
–  The annual depreciation expense is associated with the use of the asset
and therefore is not a funding mechanism.
The term ‘funding’ or ‘un-funding’ depreciation’ has been used to emphasise the need to accumulate
cash (based on the depreciation number) for the replacement of assets currently in use. This is an
incorrect interpretation of these terms. (refer AG Report 2006, pp32).
10
Observations
§  Calls to change the Australian Accounting Standards/LG Act
–  not realistic and not required
§  Disconnect between accounting assumptions and engineering
experience
–  financial reporting and asset management plans must be linked
Asset Value
(service potential)
at start of period
AMP can identify
what needs to be
done to re-instate
service potential
Depreciation
≈
AMP
Asset Value
(service potential)
at end of period
11
QTC sustainable local government
depreciation framework
QTC premise:
Asset management plans will be used to underpin accounting
assumptions in calculating depreciation expense.
§  The infrastructure asset management approach:
–  will enable informed asset management decision making
§  about infrastructure assets
§  to ensure physical and financial sustainability
–  will result in financial reporting that:
>  links to asset management plans and is supported by engineering experience/data
>  informs financial decision making
>  contributes to enhanced whole-of-council business management, and
>  promotes long term financial sustainability.
12
Benefits – robust asset management
International Standard ISO 55000
– benefits of effective asset management include:
§  improved financial performance: improving the return on investments and reducing costs
can be achieved, while preserving asset value and without sacrificing the short or longterm realisation of organisational objectives
§  informed asset investment decisions: enabling the organisation to improve its decision
making and effectively balance costs, risks, opportunities and performance
§  managed risk: reducing financial losses, improving health and safety, goodwill and
reputation, minimising environmental and social impact, can result in reduced liabilities
such as insurance premiums, fines and penalties
§  improved services and outputs: assuring the performance of assets can lead to
improved services or products that consistently meet or exceed the expectations of
customers and stakeholders
§  demonstrated social responsibility: improving the organisation’s ability to, for example,
reduce emissions, conserve resources and adapt to climate change, enables it to
demonstrate socially responsible and ethical business practices and stewardship
13
Benefits - continued
§  demonstrated compliance: transparently conforming with legal, statutory and regulatory
requirements, as well as adhering to asset management standards, policies and
processes, can enable demonstration of compliance
§  improved organisational sustainability: effectively managing short and long-term effects,
expenditures and performance, can improve the sustainability of operations and the
organisation
§  improved efficiency and effectiveness: reviewing and improving processes, procedures
and asset performance can improve efficiency and effectiveness, and the achievement
of organisational objectives.
OTHER BENEFITS:
§  Inherent in effective asset management is a greater understanding of the costs of
service provision, which will assist informed decision making and contribute positively to
long term financial sustainability.
§  A contingent benefit of financial reporting that reflects robust asset management will be
reported depreciation expense almost certainly lower than currently reported.
14
Sustainability framework
Community Plan
Long Term Financial
Forecast
Revenue Policy
Debt Policy
Asset Management Plan
Infrastructure
Capital
Financial
Capital
Planning Schemes
Priority Infrastructure Plan
Investment Policy
Corporate Plan
Budget
Operational Plan
Infrastructure Charges
Schedule
15
Long Term
Financial Plan
Financial
statements
Non current
asset accounting
policies
Asset
Management
Plans
Infrastructure assets - application of concepts
Defining characteristics of an infrastructure asset:
§  Comprised of a number of components and subcomponents that are
highly interdependent, all of which would be deemed integral to the
provision of the economic benefit but each of which can be individually
replaced to enable the life of the asset (service capacity) to continue
§  Infrastructure assets are long-life assets that experience periodic
renewal that extends their useful life
As a result infrastructure assets essentially have no defined lifespan
17
Challenges in applying the accounting
concept of depreciation
§  Recall the 3 factors required for the ‘depreciation’ calculation
Asset Value – Estimated residual value
Estimated useful life
18
Challenges in applying the accounting
concept of depreciation
§  Infrastructure assets – valuation options:
–  historic cost
–  discounted cash flow (DCF)
–  fair value concept
a)  market value
b)  depreciated replacement cost (DRC)
19
Challenges in applying the accounting
concept of depreciation
§  Infrastructure assets – valued under DRC:
–  the value for accounting purposes should reflect the minimum that it would
cost to replace that existing infrastructure asset with a technological modern
equivalent providing similar benefits
§  Think about roads, bridges, stormwater, site improvements
–  all are made up of various components and sub-components
§  Question:
–  If we were to ask a mix of 20 accountants & engineers to value the
‘road assets’ using the DRC concept, how many different results do
you think we would end up with?
20
Challenges in applying the accounting
concept of depreciation
§  The QAO 2012 audit findings depicted high volatility in infrastructure
asset valuations and minimal understanding as to the underpinning
methodology
§  Not all that surprising really
21
Challenges in applying the accounting
concept of depreciation
§  Initial valuation methodology
‒
based on a number of assumptions and judgements
§  Subsequent revaluation requirement
‒
‒
full revaluation every 5 years
option for annual desk top revaluation
§  DRC methodology and revaluations underpinned by applying ‘unit
rates’ to the components/sub-components
Question:
•  So what do you think has happened to ‘unit rates’ over recent years?
22
100
Jan-2013
Jan-2012
Jan-2011
Jan-2010
Jan-2009
Jan-2008
Jan-2007
Jan-2006
Jan-2005
Jan-2004
Jan-2003
Jan-2002
History of capital costs
180
170
160
150
140
130
120
110
Building construction - Queensland
23
Challenges in applying the accounting
concept of depreciation
Unit rates have increased over time (substantially)
Therefore infrastructure asset values have increased (substantially)
Asset Value – Estimated residual value
Estimated useful life
Assets values increase as a result of revaluation adjustments
- annual depreciation expense parallels those increases
24
Valuation methodologies - alternatives
§  Historical cost
–  short life assets (<=15 years) could be at historical cost (eg, some site
improvements)
§  Discounted cash flow (DCF)
–  DCF appropriate when valuing commercial businesses (eg, water/waste
water business operated in a commercial manner)
–  DCF valuation almost certain to be less than DRC valuation
§  Depreciated replacement cost (DRC)
–  various considerations
25
Depreciated replacement cost
- considerations
§  DRC should reflect the minimum that it would cost to replace that
existing infrastructure asset with a technological modern equivalent
providing similar benefits
§  DRC (and all valuations) to consider “Market participant buyer
viewpoint”
–  a market participant buyer would not pay a premium for:
>  excess capacity, excess redundancy, over-engineering
§  DRC valuation should recognise chosen service level
>  functional obsolescence (service levels are being reduced, technological
advances)
>  economic obsolescence (factors external to the asset)
Obsolescence allowed under Australian Accounting Standard but
seldom if ever applied to local government DRC valuations
26
Challenges in applying the accounting
concept of depreciation
§  Let’s look at the ‘estimated residual value’ element
Asset Value – Estimated residual value
Estimated useful life
–  most local governments originally set this as zero
>  the entire infrastructure asset value being depreciated
–  some local governments have amended their internal accounting policies to
include residual value estimates for their infrastructure assets
>  the inclusion of residual values lowers annual depreciation charge (due to a lower
overall depreciable amount)
–  If a residual value is used, must provide a ‘robust’ rationale as to:
>  1) why residual estimate is being included and 2) how it is determined
27
Challenges in applying the accounting
concept of depreciation
§  Let’s look at the ‘estimated useful life’ element
Asset Value – Estimated residual value
Estimated useful life
–  estimated useful lives should reflect the engineering experience and the
planned management strategy
>  underestimating useful lives will overstate annual depreciation expense
28
Challenges in applying the accounting
concept of depreciation
§  QTC premise - Estimated useful life :
–  according to the local government’s asset management strategy and asset
management plans
>  informed by engineering experience
>  reflected in the non-current asset accounting policy
–  Estimated useful life is not a product of :
>  tax schedules
>  industry standard (including IPWEA Red Book)
AMPs inform financial assumptions reflected in the NCAAP
>  AMPs are based on engineering experience and application
>  financial assumptions (NCAAP) reflect engineering reality
29
Strategies identified
§  Water/waste water
–  use a DCF approach and value under the income method if a commercial operation
–  better reflects the nature of the operations
§  Legacy assets
–  adjust DRC for economic, functional or technical obsolescence (community halls etc)
§  Roads
–  DRC valuation should recognise chosen service level for particular roads
–  some roads may not need to be depreciated
–  aligning depreciation with the asset management strategy and AMP
§  Short life assets
–  short life assets (<=15 years) could be at historical cost (eg, some site
improvements)
§  Changed business conditions
–  can adjust DRC for economic, functional or technical obsolescence
30
Where to from here
§  Robust asset management plans = robust financial reporting (QAO)
–  ensure comprehensive and robust AMPs
–  accounting assumptions supported by engineering information and the engineers
–  AMPs able to be fit for purpose; small remote vs large regional local government
–  level of confidence in the AMP content reflects in the accounting assumptions
–  council expected to comply with the spirit of the AMP; more than a compliance
exercise
Demonstrated linkage between AMPs and assumptions underpinning
calculation of depreciation expense necessary for audit support
§  Organisation wide adoption essential to success
–  will take time; no quick fix
–  local governments will need to invest resources to achieve benefits
–  benefits will greatly exceed required investment
31
Questions
32