Depreciation Options

There are two primary methods by which passive assets are depreciated, namely:

Straight Line Depreciation

• This is the traditional method for assets that have little or no value at the end of their effective life, provided that an accurate estimate can be made of that life. Straight line depreciation is calculated by dividing the original cost of the asset by its expected life.
• If the asset has remaining utility at the end of expected life, “Residual Value Depreciation” is used.

Residual Value Depreciation

• Assets which have extremely long physical lives (some over 200 years) and do not fail as a whole, but tend to fail by failure of minor component only, should have depreciation rates based on residual value.
• Although such an asset may be quite old, it often still has a large residual value and can be easily rehabilitated back to effective service for a fraction of the full replacement cost. Therefore the book or depreciated value of the asset often represents a value greater than the straight-line depreciation for its age.
• Residual Value Depreciation is calculated by determining the straight line value and adding a component for salvage or residual value.

Financial accounting rules require that the value of all assets be recorded on the organization’s “balance sheet” and that the consumption of those assets be reflected as a cost of doing organization. By reflecting the total value of all assets at the time of acquisition and subsequently showing the annual consumption of the asset until the asset is consumed, in theory an agency can quickly ascertain the remaining useful life of its “portfolio” of assets (called the “book value” of the assets).

Unfortunately, the mechanics of depreciation render the “book value” listed on the balance sheet irrelevant at best. This is because financial accounting rules require the use of historical cost. For long lived assets, the cost to replace bears little relationship to an asset’s original cost. The resulting depreciation reserve or book value does not reflect the true value necessary to replace or rehabilitate the asset, mainly due to the inflationary effect on the original cost.

”Replacement value” accounting corrects this error by using the current replacement value rather than the historic value as the basis for the depreciation calculation; however other major discrepancies arise, e.g.

• Most assets decay along a variable curve, and even “identical” or similar passive assets don't necessarily age at the same rates. Variations of 20 to 30 years are not uncommon in the same organization for the same passive asset due to the environment in which they operate and the way in which they were constructed and maintained. Therefore like assets should be treated as individual assets, i.e. "different".
• Most assets don't fail as a whole. First, minor components fail. The mode of progressive component failure may cause or can ultimately lead to total asset failure.
• Many passive assets have a substantial residual value even though they have reached the end of their physical or acceptable level of service life. Renewal/Rehabilitation techniques are being developed that allow asset owners to restore passive assets at a fraction of their replacement value.
• Many assets do not have to be returned to "as new" condition but need only be renewed to provide an acceptable level of service.

 

What effective life should be used to determine the depreciation or book value? Advanced Asset Management requires the reflection of the true depreciation (consumption) of the assets.

The first problem can be overcome by using a theoretical effective life for the first 70% of the life of the asset, and then using condition monitoring programs to set accurate residual lives for the remaining 30% of the asset’s life (the portion where most uncertainty arises). This will enable managers to model the true or actual effective life and thereby derive true depreciation.

The second problem can be addressed through condition monitoring or by the analysis of the failures that occur. If the deterioration can be predicted, or if the failures can be analyzed and avoided, then we can take proactive action to rectify these problems through maintenance/renewal program.

To overcome the third issue, considerable work has been and is being done on residual value depreciation curves for various assets. Residual value curves and tables have been developed by various sources to show the residual value at different points within the effective life eg. 72% Residual Value at 40 years of an asset with an effective life of 60 years (66% of effective life).

 

A variable effective life can be used; initially this should be the design effective life, and then at later stages, the residual life can be estimated following detailed condition monitoring. This then sets the current percent effective life of the asset, which is then used (from the graphed decay curve) to determine the book value of this asset.

For depreciation other than physical life, we need to show both the basis of the depreciation and the figure used. It would also be useful for the manager of the asset to know all the various lives of the asset, e.g.

• Design life
• Life to obsolescence
• Life to efficiency replacement (technology advancement)
• Life to capacity failure (augmentation/replacement)
• Actual physical life (mortality figure)
• Life to rehabilitation 1
• Life to rehabilitation 2
• Economic life (for cost of service rate setting).

For most assets it is important to have available several life estimates for the asset manager and maintenance staff to develop applicable strategies. These should be clearly indicated for each asset or individual asset components in the database:

• Actual Physical Life- 60 years
• Asset Strategy - Likely to be replaced due to growth in demand by 2010. Low disposal value. Maintain for reliability only.
• Effective Economic Life - 45 years (for costing purposes)
• Asset Depreciation - Write down to zero by 2010

The world is rapidly changing in:

• Available technology
• New materials and products
• Enhanced rehabilitation techniques
• Changes in the users requirements and demands for different levels of service
• Efficiency improvements.

Therefore we are going to see:

• Changes in the replacement values
• The premature aging of the old assets due to improved models or techniques with efficiency gains etc.

Consequently we need to be able to vary the effective life quickly and easily to reflect the economic or useful life of the asset rather than the actual physical capability of the asset to continue to give service. New technology may hold substantial benefits, but it often requires substantial investments in capital for the new works. In the future, asset management systems will have to provide details of both options so we can make wise investment decisions.

Good asset registers with strategic planning software will allow asset managers to continually review and revise their system models to reflect the changing times and check out various options or scenarios for the future predictions.

Abatement factors can be applied to the "current cost/current technology" figures to allow for the perceived changes, e.g.

• Will more assets be rehabilitated?
• Will maintenance costs increase/decrease?
• Will replacement values reduce?

1. THEORETICAL EFFECTIVE LIFE (DESIGN LIFE)

CURRENT REPLACEMENT COST = THEORETICAL DEPRECIATION

THEORETICAL EFFECTIVE LIFE

• HOW LONG DO WE THINK IT WILL LAST?
• HOW LONG SHOULD IT LAST?
• HOW LONG DID WE DESIGN IT TO LAST?
• WHAT IS THE OBJECTIVE / USE WE REQUIRE FROM THIS ASSET? eg. CARPET TO LOOK GOOD TO CLIENTS, OR TO LAST UNTIL THREADBARE

 

WE CAN USE THIS TO MODEL OUR ASSETS AGAINST THE USE WE NEED FROM THEM, AND THEN DRIVE THE "REAL" COST OF THE ASSETS OR THE "NECESSARY RATE OF RETURN"

2. ACTUAL EFFECTIVE LIFE (PHYSICAL DEPRECIATION)

(CURRENT LIFE + ESTIMATED RESIDUAL LIFE)

• HOW LONG IT WILL LAST?
• HOW LONG CAN WE MAKE IT LAST? (BETTER MAINTENANCE)

CURRENT REPLACEMENT COST = ACTUAL DEPRECIATION

ACTUAL EFFECTIVE LIFE

THIS DEVELOPS THE ACTUAL CASH FLOW REQUIRED.

THE REPLACEMENT/ REHABILITATION PROGRAM.

3. ECONOMIC LIFE (TECHNOLOGY LIFE)

USEFUL LIFE JUDGED ON THE LIFE BEFORE CHANGE IS EXPECTED

eg. NEW MORE EFFICIENT COST EFFECTIVE ASSET BECOMES AVAILABLE, OR SHOULD TAKE PLACE AS PART OF ORGANIZATION STRATEGY

eg. NEW PUBLIC IMAGE EVERY 10 YEARS.

Examples of Asset Depreciations Used by Some Authorities

ASSET CATEGORY	RATE OF DEPRECIATION (COSTING)	PROPOSED PHYSICAL LIFE	RESIDUAL VALUE
Land	Zero	Infinite	Market
Houses	100% x 30 yrs	50 yrs	Market
Buildings Other	100% x 30 yrs	20 yrs	Market
Portable Buildings	100% x 10 yrs	20 yrs	Market
Power Stations (Hydro)	100% x 20 yrs	60 yrs	0%
Transformers Coalfired	100% x 20 yrs	50 yrs	40%
Turbines and Generators	100% x 20 yrs	30 yrs	40%
Main/Aux Equipment	100% x 10 yrs	40 yrs	50%
Battery Chargers	100% x 30 yrs	15 yrs	0%
Transmission Lines	100% x 150 yrs	60 yrs	40%
Major Dams	100% x 80 yrs	Infinite	80%
Tunnels and Aqueducts	100% x 60 yrs	Infinite	60%
Other Water Conveyances	100% x 40 yrs	80 yrs	50%
Diversions/Drainage	100% x 10 yrs	60 yrs	50%
Communications	100% x 20 yrs	15 yrs	5%
Communications Circuits	100% x 20 yrs	25 yrs	10%
Township Services	100% x 40 yrs	40 yrs	60%
Roads and Bridges	100% x 5 yrs	40 yrs	60%
Computer Hardware	100% x 3 yrs	10 yrs	10%
Computer Software	100% x 20 yrs	10 yrs	0%
Data Acquisition/Control Systems	100% x 25 yrs	25 yrs	20%
Pumping Stations - Mechanical	100% x 30 yrs	10 yrs	30%
Pumping Stations - Electrical	100% x 5 yrs	30 yrs	30%
Tools and Equipment	100% x 5 yrs	10 yrs	40%
Computer Peripherals	15% x 5 yrs	10 yrs	10%
Aircraft	50% x 15 yrs	20 yrs	Market
Working Plant	50% x 5 yrs	20 yrs	50%
Motor Vehicles		10 yrs	Market