A European example of problems in depreciation calculations

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 13th edition:

• “The issuer both owns and operates a fleet comprising supply and subsea vessels and provides services to the subsea market. These vessels constitute a material part of the issuer’s total assets. The economic life of the vessels is estimated to be 30 years, but the useful life is 20 years since the issuer’s policy is to sell the vessels when they are 20 years old.
• The issuer estimated the residual value of the vessels to be to 50 % of acquisition cost. This residual value was assumed to be constant during the useful life. The issuer observed in its financial statements that a residual value was an estimate with a high level of uncertainty especially when the realization was over a significant period. As the average age of the fleet was six years, the expected realization would have taken place, on average, in 14 years.
• In its correspondence with the enforcer, the issuer explained that the vessel’s valuation, using discounted cash flows, was calculated based on its acquisition cost and a required rate of return. The required rate of return, used to discount the cash flows, was fixed through the useful life of the vessel. The calculation resulted in an estimated market value after 20 years of approximately 65 % of acquisition cost, which corresponded to cash flows from year 20 to year 30 discounted to the present value in year 20. The calculation did not allow for inflation.
• Older vessels have a greater inherent need for maintenance, and significant maintenance is required when the vessel is between 10 and 20 years old in order for the vessel to have a useful life of 30 years. These conditions were taken into account in the estimate, by setting the residual value to 50 % of acquisition cost and not 65 % that resulted from the annuity calculation.
• The issuer argued that the estimates used are conservative in view of an immature market with a high degree of uncertainty and presented statistics that documented that newer vessels, built after 2000, were sold for a price considerably over cost.
• Consequently, it was difficult to compare today’s vessels with eventual proceeds for the vessels for in 20 years, since the offshore market had a relatively short operating history with limited vessel sales.
• In connection with estimating the residual value, the issuer made a comparison against broker valuations. If the estimate had been based on broker valuations, the residual value would have been considerably higher than that calculated using discounted cash flows. The issuer chose not to base its assessment on broker valuations, since it would result in greater volatility in the financial reporting. The issuer had a long- term perspective and reflected only changes in long-time trends in changes of residual values.’

The enforcer (as ESMA likes to term it) didn’t accept the issuer’s calculation of residual amount, on the basis that estimating the amount based on acquisition cost didn’t comply with IAS 16.6; the issuer was required to prepare a new model taking account of broker valuations.

Information content of depreciation

In a perverse way, you have to admire ESMA’s somewhat quixotic commitment to the letter of the law in this area, as it’s hard to think of an aspect of the financial statements where the numbers have less information content. One of the low points of the Canadian conversion experience was the early paranoia about “componentization” of property, plant and equipment, raising the fear of endless analysis of ancient machinery and buildings for the purpose of a meaningless adjustment to the impenetrable depreciation numbers. Fortunately, it didn’t turn out to be quite the nightmare that some anticipated (or that some would have self-servingly hoped for it to be) and as far as I know, regulators never made much of the issue.

The situation here is a bit different, but still seems like something that should never happened; surely the real issue is the issuer’s sheer brazenness in not even trying to conform to the requirements of IAS 16. It’s plain enough that the IFRS model defines an asset’s residual value as the estimated amount an entity would currently obtain from disposing of it, if it were already of the age and in the condition expected at the end of its useful life. In many cases, it’s likely impossible (and as I said, pointless) to implement that concept more than vaguely. The irony of the ESMA example is that the issuer apparently had the information to implement it with at least adequate vagueness, based on the broker valuations, but chose not to.

Consequently, ESMA has a field day, documenting the matter in much more detail than it often applies to issues that are more important in the scheme of things. Among other things, it points out: “some vessels older than 10 years had broker values above residual value. This might have indicated that the residual value was too low, and that the issuer should have stopped depreciation at an earlier stage.” In other words, in its hapless attempt to avoid volatility (a motive responsible for leading many practitioners astray, no doubt), the poor issuer booked higher depreciation than it had to, and got sunk. The aquatic life isn’t always easy.

The opinions expressed are solely those of the author