Why Compound Depreciation is Not Used in IFRS and US GAAP

When discussing the calculation of depreciation in financial reporting frameworks like IFRS (International Financial Reporting Standards) and US GAAP (Generally Accepted Accounting Principles), it is important to note that the compound depreciation method is not used. In this article, we will explore the reasons why this method is not adopted by either of these standards, especially in light of its advantages in terms of expense in the early years and reduced income tax liability.

Understanding Compound Depreciation

Compound depreciation is a complex method of depreciating fixed assets. It involves applying a declining interest rate to the remaining book value of the asset over each subsequent period. This results in a high expense in the early years and a lower expense in later years when the balance of the asset's cost is closer to its salvage value. Essentially, it backloads the expense, allowing for a significant write-off in the initial years which can significantly lower the income tax liability in the same period.

The Government's Perspective

The government views high expenses in the early years, which lead to lower income tax liability, with considerable skepticism. Especially given the low life expectancy of many businesses, the exchequer understandably rigorously evaluates the impact of such deprecation methods. In periods where the business is still thriving and the assets are relatively new, the write-offs are high, and the tax is lower. The true write-off would take place in the later years when expenses are lower and the liability tax is higher. This uncertainty over the lifecycle of businesses complicates the government’s ability to predict and plan for tax revenues.

Lockstep Compliance with Government

Given the stringent objections from the government, it is not surprising that regulatory bodies like FASB (Financial Accounting Standards Board) and others have been reluctant to adopt the compound depreciation method. These bodies tend to align closely with government policies and regulatory requirements. FASB, in particular, has sought to maintain a balanced approach in its standards, often deferring to government financial policies to ensure long-term stability and predictability in financial reporting.

Theoretical Framework: Declining Balance Method

Wikipedia provides a comprehensive table illustrating the basic algorithm for the declining balance method of depreciation. This method is closely related to compound depreciation as it also applies an accelerated approach to depreciation. In the declining balance method, a fixed rate is applied to the book value of the asset at the beginning of each period, resulting in larger expenses in the early years and smaller ones in later years. Mathematically, this can be expressed as ( text{Annual Depreciation} text{Book Value} times text{Depreciation Rate} ), where the depreciation rate is usually a fixed percentage for all periods.

Key Considerations in Accounting Standards

The adoption of certain depreciation methods is influenced by several factors in IFRS and GAAP, such as:

Stability and Predictability: Both IFRS and GAAP aim to provide stable and predictable financial reporting for investors and stakeholders. Complex methods like compound depreciation could introduce unnecessary uncertainties. Tax Implications: The primary tax planning objectives of firms and governments must be balanced. The government desires a predictable revenue stream, and overly aggressive depreciation methods can disrupt this. Fairness and Transparency: Accounting standards also seek to ensure that financial statements are truly representative of the underlying economic events. Quick write-offs might make early financial performance look better than it is, leading to misinterpretation of the business's true performance.

Conclusion

While compound depreciation has its benefits, the lack of its use in IFRS and US GAAP can be attributed to the interplay of government concerns, regulatory compliance, and the overarching goals of accounting standards. Ensuring stability, predictability, and fairness in financial reporting remains paramount. Future revisions to these standards might still consider the adoption of more advanced depreciation methods, subject to mitigating any negative impacts on tax revenues and financial transparency.