Depreciation Expense and the Effect of Inflation

Abstract

A recent study by Skinner [1982] of United Kingdom depreciation accounting raised the question of whether it is necessary to adjust period depreciation expense to reflect the effect of inflation on firms that use equipment acquired at lower price levels in the past. Skinner compared capital consumption allowances at replacement cost as reported in United Kingdom National Income Statistics with depreciation reported in corporate financial statements. The ratio of fixed asset book values to book depreciation, compared to the ratio of fixed assets at replacement cost to capital consumption allowances, confirmed that British companies seriously underestimated the economic lives of their fixed assets. This meant that annual depreciation reported was roughly the same as if replacement cost had been used with realistic estimates of useful lives. The evidence suggested economic lives were twice as long as useful lives, and that this was not attributable to income tax regulations or attempts to allow for the effects of inflation. This paper reports on an investigation of whether United States corporations underestimate the useful lives of their assets, thereby leading to the same result. Because of the special features of the calculation of depreciation by the United States statisticians, however, I took a more direct approach to this problem by asking firms to provide estimates of the useful lives of their assets. On the basis of their responses, and in the light of recently published United States statistics on the lives of capital stocks in this country, I calculated economic depreciation for a randomly selected group of SFAS No. 33 companies, and compared it with historical cost, constant dollar, and current cost depreciation. The results of my experiment suggest that Skinner's conclusions regarding