8 October 2007

Depreciation and price regulation

Price regulation, for example in the case of a monopoly supplier, often involves determining an acceptable rate of profit. Profit is normally calculated after ‘depreciation’ i.e. taking account of the wearing out of capital assets. It is sometimes suggested that, since depreciation is not a real cost, actual capital expenditure should be used instead to determine the real profit level under different output prices, and hence the acceptable output price. In this article I argue against this approach.

1. The purpose of depreciation

According to Financial Reporting Standard 15 issued by the UK’s Accounting Standards Board, the objective of depreciation is “to reflect in operating profit the cost of the use of the tangible fixed assets (i.e. the amount of economic benefits consumed by the entity)”. The Standard adds that depreciation should be allocated to accounting periods in a way that reflects “as fairly as possible the pattern in which the asset’s economic benefits are consumed by the entity.”

The purpose of depreciation is therefore not to accumulate reserves to finance the future replacement of the assets which are being depreciated. The purchase of an asset is an expense for a company. The choice of accounting treatment is between a full write-off against profits at the time of purchase, and a gradual write-off over the useful life of the asset. In neither case is a corresponding fund set up for eventual replacement.

This view of depreciation, that it represents past rather than future expenditure, is reflected in taxation law. Some form of gradual write-off of past capital expenditure is usually allowed as a deduction in calculating taxable profit. Transfers of profit to fixed asset reserves, on the other hand, are not permitted as deductions. In the UK, this is true both for corporation tax and for petroleum revenue tax. Most other countries’ tax regimes share the same view of depreciation.

2. Return on capital expenditure

The return on a company’s investment in capital expenditure is two-fold. First, the company expects to recoup the capital expenditure over the life of the relevant assets. If it does no more than that, it is simply breaking even. Second, it expects to earn revenue over and above this break-even level during the life of the assets. This additional revenue represents its profit, and is the return on the capital employed.

The first, merely neutral, element in the return on investment is taken into account by deducting depreciation in the calculation of real profit. Hence if depreciation is excluded as a cost in calculating profit, a misleading figure for return on capital is obtained.

3. Financing of asset replacement

There are two principal sources of finance for companies. The more important of the two is internal finance, i.e. a company using its own reserves, represented by cash or short-term investments. Alternatively, a company may obtain external finance, either equity (typically by means of rights issues) or borrowing. Most finance, particularly for fixed asset replacement, is internal.

Typically companies replace fixed assets gradually each year as they wear out, and the asset replacement profile is relatively smooth over time. Since real cashflow exceeds accounting profit by the amount of the depreciation charge, this annual undistributable cashflow excess can be used to finance annual asset replacement. The match between depreciation and fixed asset replacement expenditure is likely to be reasonably close, especially if the current cost accounting form of depreciation is used.

Where the asset replacement profile is not smooth, e.g. where a large asset base is expected to wear out during a relatively narrow time-window (as may happen e.g. with oil or gas pipelines), there are two choices for what to do with the undistributable cashflow excess represented by depreciation.

First, it can be accumulated over a period of years in the form of cash or liquid investments for the purpose of eventual investment in fixed assets. Secondly, the accumulating funds can be invested in long-term projects or business operations in such a way that the funds are potentially ‘tied up’. In that case, external finance may have to be raised when the time comes for the programme of asset replacement. However, subject to capital market imperfections, this should be as efficient a way of financing the programme as the internal accumulation of funds.

A criticism of the first of these two possible approaches is that the purpose of the company from the point of view of its shareholders is to invest available shareholders’ funds in business activities which will earn a better return on those funds than shareholders could do for themselves.

Accumulating large cash or short-term investment reserves is not usually considered appropriate for a company. Companies with large cash reserves are often under pressure from shareholders and analysts to eliminate the reserves in order not to dilute return on capital employed, by using the funds for expansion.

4. Fixed asset reserves

The use of fixed asset reserves to accumulate funds specifically for the purpose of future fixed asset expenditure is not a common business practice in the UK, nor indeed in the rest of Europe or in the US. On the other hand, a company with good financial management will inevitably plan for future cash requirements by appropriate build-up of cash levels or by arranging borrowing facilities in advance.

The closest analogy in UK commercial practice is the use of so-called ‘captive insurance companies’, which are effectively ring-fenced funds designed to provide financial cover for the kinds of eventuality normally insured against, but without the owner of the captive insurance company losing ultimate control over the insurance monies.

5. The effect of price regulation

Where price regulation is based on a target rate of return on capital employed, it is sometimes questioned whether depreciation should be taken into account as an expense in calculating permitted revenue levels. For example, it was argued in relation to TransCo* that, to the extent that depreciation in a period is not matched by expenditure on fixed assets in the same period, allowing depreciation as a cost results in an excessive permitted revenue level.

To the extent that allowed revenue under the depreciation-based approach to setting revenue would exceed allowed revenue under a pay-as-you-go approach [i.e. including current capital expenditure among costs which revenue has to cover], revenue could be considered to be provided to TransCo in advance of its cash requirements. **

However, this argument fails to take into account the point about depreciation made above, namely that it represents a return of initial capital which must be covered by revenue, in addition to any ‘return’ on capital in the sense of profits, for the business to meet its objectives.

Saying that any excess of depreciation over fixed asset expenditure represents a kind of distortion can be used to argue that a justification must be found if the distortion is to be permitted. In the case of TransCo, one justification which has been proposed is that a build-up of such excesses is required to fund an eventual reversal of the situation, i.e. that in due course capital needs for fixed asset replacement will exceed depreciation charges. The authors cited above argue against this by claming that, in view of the difficulties in predicting future required fixed asset expenditure,

the uncertainty associated with the level of future capital spending may well mean that the case for any revenue advancement is weak.

This is an unsatisfactory argument since what is here called ‘revenue advancement’ is not an active process requiring judgments about the appropriate levels of advancement, but rather a case of passively allowing the existing excesses of depreciation charges over fixed asset expenditure to build up in anticipation of a future investment programme. Uncertainty over the precise amount of expenditure involved in this programme is not sufficient to undermine the validity of such ‘revenue advancement’.

One argument in favour of allowing depreciation rather than expected capital expenditure as a cost in calculating permitted revenue is that the resulting price cap is likely to be much less stable under the latter method. Annual depreciation typically has a much smoother profile over time than capital expenditure.

* now part of National Grid plc

** Arthur Andersen, TransCo 1997 price review, 3.6.

1 comment:

Sir Philip Johnston-Higham said...

I fail to see a lot of things and one is why depreciation, which is relatively smooth, as you say, is not one of the factors in capping price. I fail to see why expected and calculated capital expenditure cannot also be used. Why one or the other?