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International accounting and reporting standards include provisions that permit companies to revalue items of PP&E to fair value. When applied, all assets in the same class must be revalued annually. Such balance sheet adjustments are offset with a corresponding change in the entity’s capital accounts. These revaluations pose additional complications because they result in continuous alterations of the amount of depreciation.

It is important to note that tax methods and financial accounting methods are not always the same. This is certainly true when it comes to the subject of depreciation. For example, when the economy “slows down” governments will often try to stimulate economic investment activity by providing special incentives that are realized through rapid depreciation for tax purposes (even immediate write-off in some cases). The depreciation causes a decrease in taxable income and a company’s tax obligation. This feature can provide significant incentives for capital investment.

The history of tax laws is marked by many changes to the depreciation rates and methods. As a result, it is difficult to generalize. But, one depreciation technique is known as the Modified Accelerated Cost Recovery System (MACRS, pronounced “makers”). MACRS provides for a general depreciation system and an alternative system. Within those systems are generally provisions relating to the 200% declining balance, 150% declining balance, and straight-line techniques.

Further, tax systems will generally stipulate the useful life of an asset rather than leaving it to the imagination of the taxpayer. Tax codes tend to be very complete in identifying assets and their lives. Tax codes tend to be “favorable” to taxpayers, and generally result in depreciation occurring at a faster rate than under generally accepted accounting principles.

Is it bothersome that a company would use one accounting method for financial reporting and another for tax? Consider that accounting rules are about measuring economic activity of a business and require a proper scheme for assigning revenues and costs to time periods. Meanwhile, tax codes must be followed and often change to meet the revenue or social objectives of the government. As a result, temporary (and sometimes not so temporary) differences will arise between accounting and tax measurements. Records of these differences must be maintained, making the accounting task all the more challenging for a complex business organization.

Many businesses acquire needed assets via a lease arrangement. With a lease arrangement, the lessee pays money to the lessor for the right to use an asset for a stated period of time. In a strict legal context, the lessor remains the owner of the property. However, the accounting for such transactions looks through the legal form, and is instead based upon the economic substance of the agreement.

If a lease effectively transfers the “risks and rewards” of ownership to the lessee, then the applicable accounting rules dictate that the lessee account for the leased asset as though it has been purchased. The lessee records the leased asset as an item of property, plant, and equipment, which is then depreciated over its useful life to the lessee. The lessee must also record a liability reflecting the obligation to make continuing payments under the lease agreement, similar to the accounting for a note payable. Such transactions are termed capital leases. Note that the basic accounting outcome is as though the lease agreement represents the purchase of an asset, with a corresponding obligation to pay it off over time (the same basic approach as if the asset were purchased on credit).

Of course, not all leases effectively transfer the risks and rewards of ownership to the lessee. In the USA, the determination of risk/reward transfer is based upon evaluation of very specific criteria: (1) ownership transfer of the asset by the end of the lease term, (2) minimum lease payments with a discounted present value that is 90% or more of the fair value of the asset, (3) a lease term that is at least 75% of the life of the asset, or (4) some bargain purchase element that kicks in before the end of the lease. If a lease does not include at least one of the preceding conditions, it is not a capital lease. Instead, it is an operating lease. Rent is simply recorded as rent expense as incurred and the underlying asset is not reported on the books of the lessee. Under international accounting standards, lease accounting rules are not as specific in guidance, but are substantively similar in intent and outcome.

Why all the trouble over lease accounting? Think about an industry that relies heavily on capital lease agreements, like the commercial airlines. One can see the importance of reporting the airplanes and the fixed commitment to pay for them. To exclude them would render the financial statements not representative of the true nature of the business operation.

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