Any maintenance or asset manager knows that the longevity of assets is critically dependent on how well they are maintained. And you don’t have to be a maintenance manager to know that your car needs regular servicing. It is kind of obvious! Yet, when it comes to the important public infrastructure on which we all depend, maintenance is considered dispensable and is the first to be cut in times of financial stringency.
It is all to do with how we account for infrastructure assets. Below is the problem – and how we can overcome it using your asset management plan and condition based depreciation (CBD).
The Problem
It pays to know a little history. When government departments and agencies adopted accrual accounting practices and had to bring infrastructure assets to account for the first time, (In Australia, from 1989) naturally they turned to the private sector, where this had been the practice for many years. And this is where the first problem arose since private sector assets such as plant and machinery are depreciated over their predetermined lifespan until they reach zero or some predetermned salvage value and then they are completely replaced.
Infrastructure assets are different. This does not happen with infrastructure assets which can be kept in service for an indefinite time by piecemeal, if somewhat lumpy, component renewal. What is the age of an asset which may have some components 100 years old and others that were renewed yesterday? What is the life of an asset that can be kept in service as long as you want it to? These are unanswerable questions. They go to the heart of the difference between infrastructure and non-infrastructure assets and require a different accounting approach.
However when infrastructure assets were first brought to account, there was no alternative accounting approach for infrastructure assets, so rather than account for the entire infrastructure system, it was decided to assign each component a definite life and depreciate it as if it were an independent asset. It seemed a practical solution to a difficult problem. But in the process it completely ignored the key characteristic of infrastructure assets which is the interdependence of the components, where the life of a component, and thus the need to renew, is dependent on the other components with which it interacts. In other words, the life of components is indefinite, as is the life of the system as a whole. This does not mean infinite! It just means that you cannot define a life of a component until it reaches the stage of renewal. So depreciation in this case doesn’t work.
You will also notice something else about this approach. The economic life of any asset, as we stated at the beginning, depends on how well it is maintained, and yet maintenance does not feature in this accounting process. This is what makes it so easy for organisations to cut maintenance, since cutting maintenance does not affect the life of the asset, at least not in the accounting system – only in the real world!
The Solution
We need a better system, one that takes equal account of maintenance (minor and major) and renewal, i.e.everything that we need to spend to maintain the functionality of the asset. (In practice ‘maintenance’ and ‘renewal’ are really just different points on a continuum.)
Why do we depreciate assets at all? It is so that we can represent reduction in asset value in any particular period (asset value = its store of future services)
Is there a better way of doing this that recognises the distinct character of infrastructure assets? There is! What better way can there be of valuing the using up of asset services than the cost of making it good again? This is what is called Condition Based Depreciation (CBD). And it is available to any organisation that has a sound, and audited, AM plan as a costless spinoff. Put simply, the condition assessment of your assets that tells you what you need to spend over the planning period to maintain service function and that is in your AM Plan. It covers maintenance, minor and major and renewal and is the cost of making good the consumption of the asset over that period. You choose your planning period and it is updated on a rolling annual basis. The cost of ‘making good’ over the planning period is then expressed as an annuity to give you an annual cost and is the best estimate of real depreciation.
Second history lesson: When the UK water industry was being privatised in the early 1980s the argument was put forward that their assets should not be depreciated because the assets were continously maintained. This was rightly rejected by the accounting profession who said, in effect, ‘prove it’ and that is what a sound, audited AM plan does. Unfortunately some do not recognise the distinction between this and the AM plan backed CBD.
CBD was introduced in 1993 and has been well received by maintenance and asset managers and by practising accountants. It was adopted by the NSW Roads authority and by about a half of NZ’s councils for about ten years (until their accounting society called a halt). It is even provided as the ‘modified’ approach in GASB 34, the standard that introduced accrual accounting into the USA in 1999 but it was rejected by the Accounting Standards Board in 2004 and nothing much happened for the next 13-14 years!
Now it is back into contention because of problems with asset valuation giving depreciation figures that are artificially high and causing councils to be deemed non-viable. These councils are now scrambling to make cuts to their budget, eliminating services and sacking staff – and all at a time of Covid 19! So fictional figures are giving rise to real – and negative – physical effects. We can do better, much better!
Would CBD help bring your maintenance to the fore?
Extra references on CBD
Condition based depreciation for infrastructure assets, 1993
Depreciation of infrastructure assets
Condition based depreciation – the questions
- Extra information is provided here.
- Ask any questions you like and I will answer all of them.
Interesting article, Penny.
With the adoption of accrual accounting by local, state, territory and Commonwealth governments in Australia, there has been increased interest in methods of depreciation of long-lived physical assets.
As we know, depreciation can be a significant proportion of all operating expenses reported in the profit/loss statement.
It is important therefore to recognise that condition is one of many factors used for estimating remaining life of infrastructure assets and having a credible, reliable and up to date asset management plan recognising the implications the planned budget has on useful life, service delivery and risk is critical.
The Australian Accounting Standards Board require the useful life of an asset shall be reviewed at least at each financial year-end. The estimation of the useful life of the asset is a matter of judgement based on the experience of the entity with similar assets (and its preferred, affordable service levels) and the method of depreciation should be one that closely reflects the expected pattern of consumption of the future economic benefits embodied in the asset (AASB116).
I’m a fan of straight-line depreciation. I think it is well-suited to application with long-lived infrastructure. I agree it is important to componentise material distinct parts of long-lived complex assets that have significantly different useful lives. I also think that organisations often could be more pro-active and thorough in reviewing asset useful lives.
The IPWEA International Infrastructure Financial Management Manual (2020) (of which I am a co-author) provides clear information and guidance for asset and financial/accounting practitioners in managing infrastructure assets consistent with the International Standards including (amongst other things) depreciation, useful life, reporting indicators and supporting targets.
Thank you John.
I appreciate what you are saying. Componentisation was a workable solution at at time when we had yet to develop sound asset management plans. It made sense to the accountants who were responsible for infrastructure accounting and allowed them to treat infrastructure assets the same as other assets with which they were already familiar and thus avoided the difficulty of dealing with the different but largely unknown nature of infrastructure assets. Over the years, and I am sure, largely because of the excellent work that you and the IPWEA have done, we have all become familiar with the componentisation approach. In the process we have pushed to the background a number of problems that I believe are hampering better asset management. Now that asset management is in a much more advanced state, it may be possible to do better. So I am putting together a team of experts, asset managers, maintenance managers, accountants and academics to explore the options.
Condition Based Depreciation (CBD) (or Infrastructural accounting) has been successfully applied in the past by both State departments and local governments. For example, the NZ Auditor General (and Head of Local Government) allowed CBD as an option for his councils after hearing my paper on this subject presented to the National Accountants in Government Conference in 1993. About 1/3 to 1/2 of his councils took it up and asset management planning in NZ greatly improved, so much so that NZ is now regarded worldwide as in the lead in this field, even though Australia actually started first. Sadly, after about ten years of successful operation, the NZ Accounting Society ruled against it. It is, however, still an option in the USA, where it is referred to as ‘the modified option’ in GASB 34.
I am not the only one to believe that the issue is not as setlled as you suggest. The International Public Sector Accounting Standards Board, concerned that after 30 years of debate there is no general consensus on the way that we should treat infrastructure assets has recently commissioned a state of the art review (September 2020). This suggests the time may be right to look again at the issue and see if we cannot develop a system that is beneficial for asset management whilst at the same time being acceptable to accountants.
Maybe infrastructure accounting will prove successful, or maybe it will not, but after spending over 10 years (1993-2004) talking with several hundreds of accountants and several hundreds of engineers and getting support from both groups, I don’t want to give up without one last fight.
You have a great deal of experience and expertise in the current system but I know you to be open minded, curious, and interested in improvements. So I hope you will join us, if only to keep us on the straight and narrow. I will send more information shortly.
Penny and John,
I regard you both as one of few greatest thought leaders that can influence good change…
This is the time for it…
Straight line gives consistency. Agreed. Componentisation provides increased correctness. Agreed…
But even together it doesn’t go as far as representing reality for long life infrastructure.
20 years ago depreciation may have been appropriate the way it’s done…there was little else…
The ability now to better inform infrastructure consumption only means it’s time to shift…
Otherwise what value does it add – it’s a figure that’s not cash, does not generate revenue, has no bearing with asset performance and yet used widely in ratios…
I could be living in a city that says irrespective of our performance ie we could spend your taxes well or poorly; and your assets may deliver high or low performance ; yet we will report the same depreciation no matter what…
why would citizens not question that ?
Time to shift the game ?
Wow, how life moves in circles. Last week I was explaining CBD to a young accountant and how a change to the accounting standards killed the idea overnight.
My understanding of depreciation is, it’s an idea developed by accountants to apportion asset costs over the life of an asset as a means of more accurately estimating profits. So depreciation was never intended to reflect asset management practices and I have always felt that as a profession we have tried to hijack this measure to make our work “more relevant”.
A problem I have with CBD is that I see it as a backward looking measure but as an asset manager I want to look forwards. For example, consider a condition assessment on a 1-5 scale with 1 being new and an asset inspection finds the asset is in condition 3. I could use that information to tell me where I’ve been (ie calculate accumulated depreciation) or I could use it to work out when the asset will deteriorate to condition 5 and I have to replace it. The later information is more important to me as that tells me when I have to go beg for some money whereas depreciation is only a paper transaction.
An important point in the article is that decision makers may cut back on maintenance but not see the downsides of their decision. CBD may make things more transparent but I don’t think we need that. Instead we should strive to show how maintenance cutbacks will increase risk and/ or change customer service levels.
Many thanks Adrian. Just one point. The term condition based depreciation was created back in 1993 and it did not refer to conditions 1-5 rather it looked at what the AM plan told us that we needed to do to make good the asset consumption anticipated over whatever forward planning period was being used – thus it was most definitely forward looking, which was one of the things so good about it. Another was the point you picked up that it prevented organisations being ‘rewarded’ for cutting back maintenance. But what I liked most about it was that it was derived from the AM Plan itself so once you had a plan (which most everyone does nowadays) the calculation of asset consumption was automatically done for you, it didn’t require any fictional formula to be applied (at great time and expense). However, like all good things, if a term becomes popular it is subject to being hijacked. So any number of people took the term and used it to their own ends. Which is one of the reasons that I have now discontinued use of this term and refer to it merely as ‘accounting for infrastructure’ – please see my next post “Accounting for Infrastructure – tell us your story” (December 3) where I ask you what problems are occurring for asset managers because we are ignoring the fact that there is no finite life for infrastructure over which we can allocate costs – and because all of the elements of the infrastructure system are interdependent, they have no finite life expectation either. The application of Straight line depreciation may be convenient for accountants but it lends itself to poor asset management policies and practice. For example, see Jeff’s comment – and please add your own.