There are a three fundamental data elements to the calculation of depreciation of capital assets. They are:
- Capital Cost of Commissioning: (which is not the same as purchase price in most cases),
- Inservice date: (the day that the asset was brought into service, and
- the useful life: (or expected useful life of the asset).
I’ve had some very interesting discussions with many people about what and how to determine the useful life of water and wastewater assets. You would think that this is a relatively simple thing but there are some interesting outcomes to the choice that is made.
How does useful life affect the Tangible Capital Asset equation for a municipal financial report?
The useful life determines the rate of use of capital that corresponds to the rate of use of the asset. The ideal situation is where the rate of use of capital is equivalent to the rate of use of the asset. What is at the fundamental core of this issue is our ability as engineering managers to predict accurately the useful life of any given asset or even within asset classes.
For Engineers, there are two aspects to useful life. There is the design life or the time that we anticipate the asset will be useful based on the environmental conditions, the materials and the use of the asset. For example, some pipes last less long in corrosive soils than others. So we tend to add additional design elements to pipes that will be used in a corrosive environment to make them last longer.
The other aspect for engineers is service life. Service life is used after an asset has been assessed for its current condition. Condition assessments are used not just to identify assets that need to be replaced in a capital project list but also assets that will need to be replaced in some forecasted time frame, (otherwise known as a capital forecast). The service life is or can be changed everytime a condition assessment is performed. Everytime, we have a useful piece of information about asset condition, we want to express it as probable remaining service life.
I say probable remaining service life, because for a lot of public works assets, we don’t have very good statistics on remaining service life. Often times, we apply condition assessment statistics to broad population of pipes and the result is a number that has a very high variance. The result is that we could potentially get much more service out of some pipes and much less than others.
Let’s look at what makes sense for us to use with PSAB 3150 and the determination of depreciation of public works assets.
The cornerstone of 3150 is the use of actual costs of commissioning an asset. The cost that is used is not influenced by inflation, nor is it the replacement value of the asset. It is simply the sum total of all costs that went into bringing an asset into service. This commissioning cost is important because if we are to manage the cost that a new asset represents, we have to start with an actual number. Why don’t we use replacement cost? The replacement cost will change constantly. It will rise with metal markets and fall. It will rise with the economy and construction costs and fall with them also. What doesn’t change is the cost to bring the asset into service in the first place.
Similarly, I’ve argued that we should be using the design life as the useful of an asset for precisely that same reason. The design life is a fixed quantity of years that is (or should be) provided by the asset designer. The designer should be assessing the environmental conditions, the use conditions and making selection of materials and parts to meet those conditions. The total life cycle cost of choosing alternate options under class environmental assessment are based on this information.
Service life on the other hand is not a fixed value. It changes every time there is a condition assessment. If we use service life instead of design life to calculate our depreciation, they will be updating our depreciation schedules frequently. Let’s consider what the consequence of that might be.
To look at this, we’ll consider the example introduced by Terry Corrigan at OPWA’s AGM in Feb, 2007. In his presentation, he used an example of a concrete pipe that has a design life of 100 years, but due to soil conditions, etc is expected to have a service life of only 50 years. This is an interesting example to consider further as a piece of Use Case analysis.
In the context of practice, we would only know that the service life of a concrete pipe would be less than 100 years after it has been in service for a minimum of 30 years. We will never commission an asset with the idea that the service life is less than the design life. At the time of commissioning, the design and service life are always exactly equal. So this particular concrete pipe would be set up with a depreciation schedule of 100 years and then after 30 years, we will restate the schedule based on a change in the service life being less than the design life. We would take our original rate of depreciation over 30 years and then use the book value to restate the depreciation rate for the remaining 20 years to report an expected service life of 50 years. Once restated then we would be unlikely to report a sunk cost if the asset failed at a service life of 49 years.
There is an important value derived from this chart of rate of depreciation. In restating the rate of depreciation based on an new service life forecast derived from a condition assessment inspection, there are two major consequences. In the first case, we leave our depreciation schedule as is and when the asset does get replaced in the year 2027, we report a sunk cost of $148,500 or half the original commissioning cost. Which is not surprising as the service life was half that of the design life. For Case #2, we are going to change the depreciation schedule to account for the revised service life of 50 years instead of 100 years. Both cases are reported in the following table:
| Cases | Rate of Depreciation |
Sunk Cost on replacement/failure |
| Case #1 | $14,850.00 | $148,500.00 |
| Case #2 | $ 14,850 / 51,975 | $ 0 |
For Case #1, the municipality reports a sunk cost on an asset that did not meet expectations. In Case #2, we restated our expectations to what the asset was going to provide and end up not reporting a sunk cost. However, for Case #2, our rate that we have to offset in returning value goes from $14,850 to $51,975. This the rate by which capital must be returned to our dedicated reserve fund to return the capital value of the asset.
This example shows a general trend in municipal financial reporting. Every time we restate depreciation to reflect an expected service life, it will directly affect the need for the municpality to reflect the cost of capital. Where we actually leave depreciation as it was intended to be and report a sunk cost as a financial loss, then we are reflecting the under performance of the original asset design.
In my consideration of this to date, reporting the sunk cost of assets that fail early provides a better financial picture for a muncipality than does the constant restating of depreciation to reflect service life. This does not mean that there is not a role, an important role for use expected service life but it is not in deprecation. The important value to be gained from an updated service life is in forecasting future capital needs.
