In this accounting definition depreciation expense is based on the original cost of the asset as shown on the balance sheet. For utility ratemaking purposes depreciation expense takes its place as one of the four annual cost categories for ratemaking. The other three annual expenses are Operating & maintenance expense, taxes and return on rate base (investment).
To calculate depreciation expense the GAAP definition requires an “estimated useful life” as well as an estimate of “salvage” which includes the net of gross salvage and cost of removal. An expert in depreciation analysis is thus needed to estimate the future economic service life, salvage and cost of removal of each designated asset on the public utility’s balance sheet. This is no small task as service lives and net salvage are affected by changes in technology, economics, changes in usage, weather, regulations and consumer preferences among other factors as well.
Why is depreciation expense important?
In 2023 the Edison Electric Companies, serving 85% of US consumers, reported over $64 Billion in depreciation expenses. This is a significant number as last year Operating and Maintenance expenses were reported at $100 Billion and Net Income at $55 Billion.
That $64 Billion covers the annual expense associated with the allocation of the capital investment of the EEI member companies in generation, transmission, distribution and other assets whose rates for service at set by state regulators. The state regulators, public service commissions/public utility commissions, also have the responsibility for setting the annual depreciation rates for all those assets.
The purpose of the depreciation, as explained by GAAP, is to allocate the cost of assets over the useful lives so that the customers receiving the benefit of the service form the assets pay for the assets which they are using them. This is frequently cited as the “matching” principle. Others have expressed it as “the cost causer is the cost payer.”
Incorrect estimates of service life can lead to assets being retired before they are fully depreciated, in which case the regulator is faced with a decision concerning the “stranded cost” or the unrecovered amount of the original cost of the assets.
An incorrect estimate resulting in full depreciation with the assets remaining in service has less of a negative impact in that the asset is no longer in rate base and the consumer neither pays any future depreciation expense on it nor has to pay any return on the fully depreciated asset. But the matching principle is still violated.
Given the complexity and significance of depreciation, the estimates of annual depreciation expense for the numerous and complex asset accounts of regulated electric utilities are best left to experts trained in depreciation analysis. In that case we have a problem. Most state public service commission and electric utilities do not have permanent staff trained in depreciation.
At one time a few university engineering departments such as those of Iowa State University and Michigan State University offered courses in depreciation and valuation. That is no longer the case. The only professional training and certification now available is from the Society of Depreciation Professionals www.depr.org established in 1987.