Budget Issues: The Role of Depreciation in Budgeting for Certain Federal
Investments (Staff Study, 02/95, GAO/AIMD-95-34).

This staff study explores the applicability and the usefulness of
depreciation in federal budgeting for spending on transportation
infrastructure, research and development, and human capital. GAO's
review of professional literature and consultation with budget and
accounting experts did not support depreciating such investment in
federal budgeting as useful or appropriate because (1) it could
undermine budgetary control, (2) it would result in depreciating assets
the government does not own, and (3) determining the value and the
useful life of these investments would be difficult.  Although GAO does
not view depreciation for these types of federal investments as an
appropriate budgetary treatment, it does believe that federal
investments with long-term potential benefits for economic growth and
productivity should be considered differently than they now are in the
budget. One option is to include an investment component in the budget
focusing on these areas of investment within the Budget Enforcement Act
framework, possibly with a separate floor for investment spending, to
help focus attention on areas needing investment while preserving
established controls in the existing budget process.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  AIMD-95-34
     TITLE:  Budget Issues: The Role of Depreciation in Budgeting for 
             Certain Federal Investments
      DATE:  02/01/95
   SUBJECT:  Budgeting
             Investment planning
             Investments
             Economic development
             Economic growth
             Economic policies
             Federal programs
             Depreciation
             Assets
             Accounting procedures

             
**************************************************************************
* This file contains an ASCII representation of the text of a GAO        *
* report.  Delineations within the text indicating chapter titles,       *
* headings, and bullets are preserved.  Major divisions and subdivisions *
* of the text, such as Chapters, Sections, and Appendixes, are           *
* identified by double and single lines.  The numbers on the right end   *
* of these lines indicate the position of each of the subsections in the *
* document outline.  These numbers do NOT correspond with the page       *
* numbers of the printed product.                                        *
*                                                                        *
* No attempt has been made to display graphic images, although figure    *
* captions are reproduced. Tables are included, but may not resemble     *
* those in the printed version.                                          *
*                                                                        *
* A printed copy of this report may be obtained from the GAO Document    *
* Distribution Facility by calling (202) 512-6000, by faxing your        *
* request to (301) 258-4066, or by writing to P.O. Box 6015,             *
* Gaithersburg, MD 20884-6015. We are unable to accept electronic orders *
* for printed documents at this time.                                    *
**************************************************************************


Cover
================================================================ COVER


Staff Study

February 1995

BUDGET ISSUES - THE ROLE OF
DEPRECIATION IN BUDGETING FOR
CERTAIN FEDERAL INVESTMENTS

GAO/AIMD-95-34

Depreciation


Abbreviations
=============================================================== ABBREV

  BEA - Bureau of Economic Analysis
  CBO - Congressional Budget Office
  DOT - Department of Transportation
  FASAB - Federal Accounting Standards Advisory Board
  FASB - Financial Accounting Standards Board
  GAO - General Accounting Office
  GASB - Governmental Accounting Standards Board
  IASC - International Accounting Standards Committee
  NSF - National Science Foundation
  OECD - Organization for Economic Cooperation and Development
  OMB - Office of Management and Budget

PREFACE
============================================================ Chapter 0

In this study we explore the applicability and usefulness of
depreciation in federal budgeting for spending on transportation
infrastructure, research and development, and human capital.  Such
spending is intended to provide future benefits primarily in terms of
increased long-term private sector economic growth.  We have defined
this spending as investment.\1 Depreciating these investments and
appropriating annual depreciation charges would conceivably be one
way to spread the costs of these investments over time.\2 While we
previously reported\3 that the use of depreciation presents many
practical difficulties in making budget decisions about levels of
federal investments, we believe that more research in this area
contributes to the overall debate about capital budgeting. 

In addition to investment spending, the federal government makes
other expenditures of a capital nature which are intended to provide
future benefits to the government as an operating entity; examples
are office buildings and computer systems.  There might be benefits
from some change in the budget treatment of this type of spending,
but that issue was not the subject of the request and, therefore, is
not addressed in this study.  It needs to be considered separately on
its own merits. 

We found widespread agreement among accounting and budgeting experts
that the federal government generally does not depreciate
transportation infrastructure, research and development (R&D), and
human capital for either accounting or budgeting purposes.  In our
research we found no evidence that states or private sector
businesses use depreciation in budgeting for any of these types of
investments.  However, economists depreciate infrastructure and R&D
investments in their more global analyses to make rough estimates of
national wealth. 

We found virtually no sources that identified methods by which these
investments could reasonably be depreciated for federal accounting or
budgeting purposes.  Our review of the professional literature and
consultation with budget and accounting experts did not support
depreciating such investments in federal budgeting as useful or
appropriate because (1) it could undermine budgetary control (2) it
would result in depreciating assets the government does not own, and
(3) determining the value and useful life of these investments would
be difficult to do. 

We believe that depreciation for these types of federal investments
is not an appropriate budgetary treatment.  However, we do believe
that federal investments with long-term potential benefits for
economic growth and productivity should be considered differently
than is presently done in the budget.  One option we have previously
discussed\4 is to include an investment component in the budget
focusing on these areas of investment within the Budget Enforcement
Act framework, possibly with a separate floor for investment
spending, to help ensure attention to these needed areas of
investment while preserving the established controls in the current
budget process. 

We are sending copies of this study to interested congressional
committees and the Directors of the Office of Management and Budget
and the Congressional Budget Office.  Copies will also be made
available to other interested parties on request. 

Major contributors to this study are identified in appendix I. 

Paul L.  Posner
Director, Budget Issues
Accounting and Information Management Division


--------------------
\1 For example, see Budget Policy:  Prompt Action Necessary to Avert
Long-Term Damage to the Economy (GAO/OCG-92-2, June 5, 1992) and
Federal Budget:  Choosing Public Investment Programs (GAO/AIMD-93-25,
July 23, 1993). 

\2 This study addresses depreciation broadly as a concept.  Many of
the issues raised in this study would also apply to other methods of
spreading costs over time such as depletion accounting in the case of
natural resources and amortization in the case of certain intangible
assets. 

\3 Budget Issues:  Incorporating an Investment Component in the
Federal Budget (GAO/AIMD-94-40, November 9, 1993). 

\4 Budget Issues:  Incorporating an Investment Component in the
Federal Budget (GAO/AIMD-94-40, November 9, 1993). 


INTRODUCTION
============================================================ Chapter 1


   BACKGROUND
---------------------------------------------------------- Chapter 1:1

Concerns about long-term national economic growth have focused
attention on the federal government's role in promoting investment
necessary to sustain the economy's capacity to maintain and improve
future living standards.  The federal government contributes to
investment in two primary ways. 

First, the federal government can facilitate private investment by
reducing the federal deficit.  Federal budget deficits have absorbed
large proportions of national savings that would otherwise have been
available to finance investments, either public or private. 

Second, within an established fiscal policy, the federal government
can change the proportion of government spending devoted to
investment.  In the past, federal investments in infrastructure,
human capital, and R&D have played a key role in economic growth,
either directly or by creating an environment conducive to private
sector investment. 

Both the Congress and the administration are considering budgeting
alternatives to decrease the annual federal deficit while increasing
long-term federal investment intended to enhance private sector
growth.  Some discussions have focused on capital budgeting and the
possible use of depreciation in the budget as a measure of the cost
of federal investments which deliver benefits over a future period of
time.  These investments include infrastructure such as highways,
bridges, and air traffic control systems; R&D, which produces new
technology that leads to innovative products and processes; and
investments in human capital through education and training designed
to increase worker productivity. 

Depreciation is an integral component in capital budgeting--a
proposal contained in several bills in recent years.  A capital
budget approach using depreciation would report total acquisition
costs of the investment in a capital budget and the annual
depreciation in an operating budget.  The cost of the investment
recorded in the operating budget would thus be spread over the
estimated life of the investment.  The operating budget would reflect
the cost of goods and services consumed rather than purchased during
the period.\1 Under most capital budgeting proposals, the operating
budget must balance while the capital budget may be financed by
borrowing.  By contrast, the federal budget is a unified cash-based
budget which treats outlays for capital and operating activities the
same.  Federal debt is undertaken for general purposes of the
government rather than for specific projects or activities. 

Three views have been cited in support of proposals to depreciate
investments in the federal budget.  First, the long-lived nature of
the benefits arising from these investments causes some analysts to
believe that their costs should also be spread over time by some
method of depreciation so that costs are shared by those who will
benefit in the future.\2 Second, some analysts believe that because
the initial cost of these investments is high, budgeting for the full
commitment up-front discourages investment and favors consumption
spending.  Finally, proponents believe that budgeting for
depreciation instead of the full commitment up-front frees up
budgetary resources for greater investment or other uses in the
current period and reduces the current year's deficit. 

Other analysts, taking an opposing view, believe that depreciation
would not really free up resources or reduce the deficit.  Such a
proposal would only redefine the deficit to be controlled as the
operating budget deficit rather than the larger unified budget
deficit.  This would mean that any spending categorized as "capital"
would not be subject to the same pressures to reduce the deficit as
any other federal spending.  Thus, it might be used to justify larger
unified budget deficits and borrowing.  In addition, they believe
that appropriating annual depreciation instead of the amount of the
full commitment undertaken by the government poses a loss of
budgetary control that would threaten the integrity of the budget and
the budget process. 


--------------------
\1 Some private sector businesses include depreciation in their
operating budgets, but those operating budgets are totally
accrual-based and, therefore, similar to income statements.  They
are, therefore, unlike the operating budgets described in most
capital budgeting proposals for government.  Businesses use cash and
capital budgets to allocate financial resources. 

\2 The concept of generational equity includes matching revenues and
expenses during a period to determine if each generation is paying
for the services it receives. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:2

The objectives of this review were to determine (1) whether federal
agencies are depreciating transportation infrastructure, R&D, and
human capital for accounting and budgeting purposes, and if so, the
methods they use, (2) whether any state, local, or foreign
governments are depreciating these investments, and (3) whether
depreciation of these investments could be useful in budgeting. 
Based on the items traditionally included in these categories, we
define infrastructure as federally funded physical transportation
assets, such as highways, bridges, railways, and air traffic control
systems.  We define R&D as federally funded activities intended to
produce new or improved products or processes.  For purposes of this
study, we define investment in human capital as federally funded
education and training programs. 

To meet these objectives, we discussed the concept of depreciation as
a budgeting tool with professional staff at the Office of Management
and Budget (OMB), the Congressional Budget Office (CBO), the
Department of Commerce's Bureau of Economic Analysis (BEA), and the
Organization for Economic Cooperation and Development (OECD).\3

We also discussed depreciation from an accounting and budgeting
perspective with officials at the Departments of Education and
Transportation, the National Science Foundation, the Federal Highway
Administration, the Federal Aviation Administration, and the Federal
Railroad Administration.  We reviewed articles in budgeting and
accounting professional journals on the use of depreciation in
federal budgeting and accounting. 

We reviewed relevant standards issued by the Financial Accounting
Standards Board (FASB), the Governmental Accounting Standards Board
(GASB), and the International Accounting Standards Committee (IASC). 
We also reviewed Title 2 of the GAO's Policy and Procedures Manual
for Guidance of Federal Agencies, and standards drafted by the
Federal Accounting Standards Advisory Board (FASAB) dealing with
depreciation.\4

To specifically address the second objective, we reviewed the GASB
standards to determine if state and local governments are required to
treat depreciation of infrastructure, R&D, and human capital for
financial statement purposes.  We also interviewed officials from
federal agencies, OECD, and two consultants regarding the budgeting
practices of foreign governments.  We discussed the experience of New
Zealand with these experts because of its recent adoption of
accrual-based budgeting.\5

We performed our work in Washington, D.C., between June and December
1994. 


--------------------
\3 OECD is an international organization, comprised of 24 democratic
nations with advanced market economies whose aim is promoting
economic and social welfare throughout the OECD area. 

\4 FASB provides accounting standards for the private sector in the
United States; GASB provides accounting standards for state and local
governments; and IASC provides private sector standards for the
international community.  Title 2 provides accounting standards
established by the GAO for federal agencies.  FASAB was established
in 1990 to consider and recommend accounting principles for the
federal government. 

\5 Accrual-based budgeting includes depreciation of certain assets
for budgeting purposes. 


DEPRECIATING FEDERAL INVESTMENTS
============================================================ Chapter 2


   DEPRECIATION IN ACCOUNTING
---------------------------------------------------------- Chapter 2:1

Depreciation is an accepted part of accounting in business
organizations.  Under business accounting practices, depreciation is
the allocation of the costs, less salvage value, of fixed assets,
including equipment, buildings, and other structures, over their
useful lives in a systematic and rational manner.  It is recorded in
the business' financial statements to reflect the use of assets
during specific operating periods in order to match costs with
related revenues in measuring income and to determine the
organization's profit or loss, its federal tax liability, and the
depreciated book value of the asset.  It is also a factor in
determining the cost of manufactured items and the amount of user
charges appropriate for services rendered. 

Depreciation of assets in federal accounting is often not done
because it is difficult to do and often provides little relevant
information.  In the past, federal accounting standards for
non-business-type activities established by GAO, known as Title 2,
encouraged, but did not require, depreciation of general tangible
assets.  However, Title 2 did require depreciation accounting for all
federal business-type activities in cases where depreciation of
federal assets were used to establish sales prices or user charges
necessary to reimburse revolving funds or otherwise recover costs.\1

In these cases, federal agencies do depreciate the relevant assets to
determine user charges to recover the cost of the asset.  Presently,
FASAB is considering standards that would require federal agencies to
depreciate infrastructure assets owned by the federal government, but
probably not intangible investments such as R&D and human capital.\2

GASB, which sets accounting standards for state and local
governments, prohibits recording annual depreciation charges in
financial statements for the general fund because these funds do not
operate on a strictly accrual basis.  Depreciation, which is an
expense, applies only to accrual-based accounting systems.  GASB
standards, however, do require the reporting of depreciation in
financial statements for proprietary and certain trust fund assets
because these funds are reported on an accrual rather than a cash
basis. 

If depreciation methodologies were to be used in federal budgeting,
one starting point for establishing those methodologies conceivably
would be the accounting methods used for depreciation of tangible
assets for financial statement purposes.  Depreciation in accounting
can be a complex and technical subject and involves significant
subjectivity concerning such key factors as the asset's value, its
useful life, and its salvage value.  Because of its subjective
nature, it is only an approximation of how much of an asset is used
up in any period.  Ultimately, depreciation of tangible assets is an
imperfect way of spreading costs over the asset's useful life. 
Trying to apply depreciation accounting techniques to intangible
assets such as R&D and human capital investment for either accounting
or budgeting purposes would be even more difficult because of the
additional difficulties in estimating value, useful life, or
establishing ownership. 


--------------------
\1 Currently, the accounting standards to be used by federal agencies
are set forth in Interim Accounting Standards Guidance approved by
GAO, OMB, and Treasury.  It specifies the following hierarchy of
federal accounting standards:  (1) individual standards approved
through the FASAB process, (2) OMB Form and Content requirements, (3)
accounting standards contained in agency manuals as of March 29, 1991
(these may have been based on Title 2), and (4) accounting principles
published by other sources in the absence of guidance from (1)
through (3). 

\2 The depreciation of general tangible assets will be addressed in a
FASAB exposure draft on Accounting for Property, Plant and Equipment
which is planned to be issued for public comment in early 1995. 
Accounting standards for human capital and R&D are expected to be
incorporated in the Statement of Stewardship exposure draft which is
planned to be issued for public comment in the spring of 1995. 


      BASIC DEPRECIATION
      CALCULATIONS
-------------------------------------------------------- Chapter 2:1.1

Calculating the amount of depreciation to be recorded annually
depends on how assets are valued to determine the depreciation
base,\3 the depreciation method used, and the asset's useful life. 


--------------------
\3 The depreciation base is the recorded costs or other value basis
of a fixed asset that is to be recovered through depreciation,
excluding estimated recovery from resale or salvage. 


         ASSET VALUATION
------------------------------------------------------ Chapter 2:1.1.1

There are three general ways to value assets--historical cost,
constant cost, and current cost.  Historical cost is the amount of
cash (or its equivalent) paid to acquire an asset and is considered
to be an objective and verifiable basis for valuation.  Constant cost
restates historical cost information in terms of dollars of equal
purchasing power.  Current cost is the amount of cash or other
consideration that would be required today to obtain the same asset
or its equivalent.  Market prices are often used to determine current
cost.  Which of these valuation methods is chosen greatly affects the
depreciation base.  While historical cost is most widely used and
documented, current cost provides a more relevant measure of the
resources tied up in a particular asset and the cost to replace the
asset.  After an asset is valued (usually at historical cost), one of
numerous depreciation methods is then selected to spread the
depreciation base over the asset's useful life. 


         DEPRECIATION METHODS
------------------------------------------------------ Chapter 2:1.1.2

Depreciation computations are based on the assumption that every
fixed asset (except land) has a limited useful life.  The value of
the asset (or depreciation base, as described previously) is thought
of as a prepaid expense that by some method must be spread over the
asset's useful life.  Various methods have been developed to do
this--among the most well-known are the straight-line,
declining-balance, and replacement cost methods.  The straight-line
method is the simplest and most commonly used.  Other methods that
can be more complicated have been advocated or approved by
accountants for income tax and other purposes.  The following
describes the three methods mentioned above. 

The straight-line method spreads the depreciation base equally over
the useful life of the asset. 

The declining-balance or geometric method determines the annual
depreciation charge by applying a fixed percentage to the diminishing
value of the asset, that is, the asset's value after deducting the
preceding year's depreciation charges. 

The replacement method considers the asset's replacement cost and
increases the current depreciation charge by a percentage based on a
comparison of the anticipated replacement cost with the recorded
cost. 

Selecting an appropriate depreciation method depends on the purposes
for which depreciation is being recorded.  In our review, we found
that depreciation of transportation infrastructure, R&D, and human
capital investments in the public sector was used primarily by
economists for analytical purposes such as estimating economic
wealth.  Many economists identified the replacement method as the
appropriate method for economic analysis because it provides the
closest estimate of true economic cost. 


   STATUS OF DEPRECIATING FEDERAL
   INVESTMENTS
---------------------------------------------------------- Chapter 2:2

In general we found that none of the three types of federal
investments we examined--transportation infrastructure, R&D, and
human capital--are depreciated for either accounting or budgeting by
federal agencies.  We did find that some consideration had been given
to depreciating infrastructure because physical assets are
depreciated in the private sector, and its tangible nature provides a
reasonable basis for discussion.  However, investments for R&D and
human capital had received little attention because they are not
depreciated in the private sector and the intangible nature of these
assets made issues of valuation and ownership difficult to determine. 


      DEPRECIATION OF
      INFRASTRUCTURE INVESTMENTS
-------------------------------------------------------- Chapter 2:2.1

The Department of Transportation (DOT) administrations that we
reviewed--the Federal Highway Administration, the Federal Aviation
Administration, and the Federal Railroad Administration--do not
depreciate transportation infrastructure investments for accounting
or budgeting purposes.  The reason given for this is that the federal
government does not own most of the transportation assets it funds. 
The federal government funds most transportation infrastructure
through grants.  For example, the federal government spent more than
$24 billion on physical transportation investments in 1993, but more
than $21 billion of this spending was in the form of grants. 

Generally accepted accounting principles established by FASB provide
that infrastructure assets owned by the reporting entity, such as
railroad tracks owned by the entity, are depreciated in the entity's
financial statements.  At this time, federal accounting standards for
infrastructure assets not owned by the federal government do not
provide for recording grantee assets for purposes of depreciation. 
FASAB is considering standards for infrastructure assets owned by the
federal government, but not for infrastructure grants or assets owned
by grantees. 

DOT analysts cited two major problems with depreciating assets which
DOT does not own.  First, it is often difficult, and in some cases
impossible, to link federal grant money to the value of a specific
infrastructure asset.  In part, this is because it is difficult to
distinguish how the federal share of funding is used when mixed with
funding from other sources.  It is also difficult to assign value to
portions of a project that are only components of larger projects. 
Also, if federal investment expenditures cannot be linked directly to
an asset, there is no basis for determining a useful life over which
to spread the cost. 

A second problem cited by analysts at DOT is the difficulty of
monitoring the value of an asset not owned by the entity seeking to
depreciate it.  The owners of an infrastructure asset can improve or
discard that asset at their own discretion, although in the case of
highways the federal government may share in any monetary return
resulting from disposition.  Applying the concept of depreciation to
federal grants could result in a situation in which an annual
depreciation charge would appear in the federal budget for an asset
that is not owned by the federal government or that may not even
exist any longer. 

Analysts at DOT said that the effort that would be required to
determine the value of depreciable transportation assets funded by
grants would be large and would detract from DOT's other missions. 
Officials at these agencies expressed strong doubts that the benefits
from depreciating these infrastructure investments would justify the
cost of determining the assets' value. 

Among the 24 OECD nations, none appropriates depreciation for
infrastructure assets in its national budget.  Even New Zealand, the
only OECD nation that uses depreciation in its budget, does not
appropriate depreciation for infrastructure assets that are owned by
the government as a whole.\4 New construction of roads and other
infrastructure assets owned by the New Zealand government as a whole
are appropriated up front on a cash basis.  In this instance, New
Zealand's system is, in principle, similar to the system that is used
to budget for highways in the United States.  Infrastructure assets
not owned by the New Zealand government are not depreciated by the
government for either budgeting or financial reporting purposes. 
However, for accounting purposes, in cases where the government owns
transportation infrastructure assets, the assets are depreciated
using the current replacement cost method in the government's
financial statements. 


--------------------
\4 Depreciation on assets owned by individual departments, such as
office buildings, is included in each department's budget. 


      DEPRECIATION OF R&D
      INVESTMENTS
-------------------------------------------------------- Chapter 2:2.2

Officials at the National Science Foundation (NSF) told us that they
do not depreciate R&D and advised us that they could imagine no
reasonable method or practical reason for doing so.  Major
impediments to depreciation include establishing the value and useful
life of R&D.  Also, NSF's R&D funds are usually disbursed through
grants for which there is no established method of depreciation. 

Depreciation of R&D investment has been proposed and considered for
the private sector, but not practiced.  FASB prohibits capitalization
and depreciation of any R&D expenses by private sector entities,
including the R&D costs of internally developed computer software. 
Depreciation of R&D was rejected because of the uncertainty and
difficulty in measuring the benefits and the inability to determine
useful life. 

From an international perspective, the IASC provides that in limited
cases R&D expenditures may be deferred and depreciated if they result
in a product or process that is technically and commercially feasible
and can be marketed.  In our review, we found only one OECD
government, New Zealand, that provided for depreciation of R&D to a
limited extent in its budget, and then only for R&D owned by the
government. 

In New Zealand, government R&D expenditures generally are expensed as
incurred in both the budget and financial statements.  However, they
can be capitalized and depreciated in both if they result in a
product or process which is demonstrated to be technically useful and
is intended to be used or marketed.  In cases where this is
anticipated, depreciation is deferred until a market asset is
produced.  At that point, the R&D expenditures (based on historical
cost) are depreciated over the expected period of future benefits,
allowing for a more accurate assessment of costs for the period. 
Otherwise, R&D expenditures are reported as expenses for that year. 


      DEPRECIATION OF HUMAN
      CAPITAL
-------------------------------------------------------- Chapter 2:2.3

We found no government that capitalizes or depreciates human capital
in any budget or financial statement.  At the core of this issue
there is a basic unresolved question as to whether human capital
depreciates or appreciates over its relevant life.  Officials at the
Department of Education told us they had discussed the concept of
depreciating human capital, but did not find it cost beneficial or a
useful tool.  Similar to the DOT with its highway grants, the
Department of Education funds education and training mostly through
grants\5 for which there is no standard or methodology for
depreciation.  In the academic literature we reviewed, there is
general agreement that the problems preventing the acceptance of
depreciation of human capital are insurmountable in part because of
the inability to determine the useful life and real value of
education and training spending. 

In the private sector, various methods for recognizing in financial
statements the value of a firm's employees have been developed and
proposed over the last 30 years.  However, no standard for reporting
human capital has ever been accepted, or even seriously considered,
because (1) the methods are complicated and difficult to apply and
(2) the methods used to determine values for human capital are
subjective and open to challenge. 

The methods that have been developed apply only to specific firms and
are not intended to measure the value of human capital outside the
firm.  Thus, even if they were accepted as valid, they are not
applicable to the education and training expenditures that
governments would make, which are primarily for the benefit of the
general public. 


--------------------
\5 The Department of Education also funds education and training with
loans and loan guarantees.  The Credit Reform Act of 1990 provides a
methodology for controlling and accounting for these credit programs
in the budget. 


      DEPRECIATION FOR NATIONAL
      ECONOMIC WEALTH ESTIMATES
-------------------------------------------------------- Chapter 2:2.4

Although federal investments in transportation infrastructure, R&D,
and human capital are not depreciated for budgeting or accounting
purposes, OMB and BEA depreciate infrastructure and R&D investments
to make rough estimates of national wealth for analytical purposes. 
Depreciation is considered to be appropriate for generating national
economic wealth estimates because it is used only to provide rough
estimates of the value of existing assets in the economy.  In these
economywide analyses, the problems of determining ownership or
control of assets are not relevant.  However, the analysts who
generate these estimates maintain that this type of analysis is
inappropriate for budgeting because (1) the estimates are imprecise
and dependent on questionable assumptions and (2) because measures of
stocks have no place in a budget that allocates resource flows. 

In making national economic wealth estimates, the BEA and OMB use a
valuation method called the perpetual inventory method.  In this
method, the gross federal investment for the year is added to the sum
of previous years' net investments.  This sum is then reduced by
depreciation and estimated discarded investment to determine net
investment.  All OECD nations use the perpetual inventory method in
estimating their national wealth. 

BEA and OMB have both estimated the value of the stock, that is,
inventories, of physical capital investments including
infrastructure.  In making estimates of the value of the nation's
stocks of economic wealth, BEA depreciates the estimated stock of
infrastructure assets valued on historical cost, constant cost, and
current cost bases using straight-line depreciation over a 50-year
estimated useful life.  OMB estimates the total net federally
financed physical capital stock including transportation stocks,
regardless of ownership.  OMB made its estimates using a constant
dollar adjustment to historical federal spending for transportation
and depreciated it on a straight-line basis.  The transportation
stocks are depreciated over a 40-year estimated useful life.  These
estimates are produced for economic policy information. 

OMB has also estimated the stock of federally financed research and
development.  In making these estimates, OMB assumed that basic
research did not depreciate but applied research and development
depreciated, using the geometric method, at a 10 percent rate.  BEA
recently published estimates of the national R&D stocks.  In making
its estimates it depreciated all R&D, including basic research using
a method equivalent to an 11 percent geometric rate.  In the
President's 1995 budget, OMB estimated the stock of the nation's
education capital based on an estimate of what it would cost to
reeducate the population at 1987 prices.  They did not assume any
depreciation of education over an individual's lifetime.  BEA has
made no attempt to estimate the stock of human capital. 


   DEPRECIATION AS A BUDGETING
   CONCEPT
---------------------------------------------------------- Chapter 2:3

We found widespread agreement among accounting experts published in
professional journals, budget experts, and economists at BEA and OECD
that the use of depreciation is not well suited to a cash and
obligation-based budget like that of the United States.  Depreciation
as envisioned in most capital budgeting proposals is not currently
done in the federal budget.  Appropriations and outlays are normally
recorded on a cash basis in the budget.  Thus, in general, the total
commitment of the government in making an investment is usually
recorded up front, not spread over the useful life of the investment. 

No state records annual depreciation in its capital or operating
budgets because depreciation has no effect on the flow of current
financial resources.  However, an important task of state capital
budgets is to relate the purchase of some of a state's fixed assets
to borrowing and other specified types of financing. 

Business enterprises do not include depreciation of capital assets in
their budgets.  Businesses do, however, include a cost of capital
(primarily principal and interest payments) in their financial
budgets.  Textbooks on private business budgeting practices indicate
that depreciation is irrelevant for budgeting except where income
taxes are affected.  Private businesses use depreciation primarily
for two purposes:  (1) to match revenues with expenses in a given
period for the purposes of reporting profit or loss in financial
statements and (2) for tax purposes.  Neither of these purposes,
however, are applicable to federal budgeting, except for federal
business-type activities which consider revenues and expenses in
setting user fees. 

Of the OECD member nations only one, New Zealand, uses depreciation
in its budget.  New Zealand began to apply depreciation to budgeting
in 1992 as a part of its transition from a cash to an accrual-based
budgeting system.  New Zealand's accrual-based budgeting system
includes depreciation for department or agency-owned physical assets
in the budget statements where the depreciation is appropriated as
part of the cost of departmental operations.  However, assets owned
by the government as a whole, such as transportation infrastructure
and some R&D, are depreciated in the financial statements, but are
not appropriated in the budget.  New Zealand does not depreciate
expenditures for human capital in either its financial or budget
statements. 

In talking to budget experts, we identified four major disadvantages
in the use of depreciation for federal investments in infrastructure,
R&D, and human capital:  (1) loss of budgetary control, (2)
increasing uncertainty over budget estimates, (3) obscuring the
effect of budgetary decisions on the deficit, and (4) concern with
depreciating assets not owned by the federal government. 

The greatest disadvantage according to these experts was that
depreciation would result in a loss of budgetary control under an
obligation-based budgeting system.  In general, the federal budget
records the full cost of its spending decisions up front in terms of
both budget authority and outlays so that decisionmakers have the
information needed and an incentive to take the full cost of any
decision into account.  The only time that spending on a federal
investment can be controlled is before obligations are made.  After
obligation, recipients of the spending expect it to occur and the
government is generally committed to payment of all the costs. 
Depreciation, on the other hand, would spread that cost over the
asset's expected useful life.  The focus of control for the operating
budget--the component that would be subject to a balanced budget
requirement--would not be on the total up-front government commitment
because, by the time the commitment would be fully recognized in the
operating budget, the expenditures would have already been made. 
Although decisionmakers would consider the up-front costs of an
investment in the capital budget, this budgetary component would not
be subject to resource constraints or balanced budget requirements,
thereby diminishing the incentives to carefully weigh total costs and
benefits. 

This loss of budget control would be evident in two ways.  First,
under Budget Enforcement Act provisions, investment spending would be
transformed from a discretionary decision in the current year to a
stream of sunk mandatory payments in future years to finance the
depreciation charge.\6 This would diminish budgetary flexibility in
the discretionary portion of the budget.  Second, without the
establishment of some new method of control, depreciation of
investments would nearly eliminate budgetary constraints on current
investments.  Since assets are only depreciated after they have been
fully constructed and put into service, outlays for current
investments would not be recognized in the operating budget until the
annual depreciation charges began.  For example, spending on the
recently cancelled Superconducting Super Collider would not have been
included in any prior year's budget nor have been subject to any
spending cap\7 because it was never put into service.  In addition,
all previous spending would appear in the budget in the year it was
cancelled, setting up a perverse incentive to continue the program
rather than to absorb the accumulated past spending in 1 year. 

Depreciation could be applied to the federal budget process only if
it were accompanied by new methods of control that would provide
discipline for making up-front commitments that would not destroy
budgetary integrity.  For example, when New Zealand included
depreciation in its budgetary process, it substantially reformed its
budget process to include new controls on agencies.  These controls
included the imposition of asset caps and the establishment of output
contracts which established performance goals for agency heads. 

A major disadvantage to using depreciation in the federal budget
cited by budget experts is its effect on the quality of budget
estimates.  They are concerned that depreciation of investments would
make budget estimates uncertain and/or unreliable.  Determining any
asset's useful life is a complicated technical exercise that is
inherently subjective.  For example, OECD recently surveyed the
useful lives over which capital equipment was depreciated in 14 OECD
countries and found wide discrepancies in the average life for the
same categories of assets.  The range for capital equipment was 11
years in Japan to 26 years in the United Kingdom.  Uncertainties
about the useful lives for assets with possibly indefinite lives,
such as highways, and intangible assets, such as R&D and education,
would be even greater.  Cash flows provide a more certain and more
objective basis for making budgetary decisions. 

Another major disadvantage cited by budget experts is the claim that
depreciation would undermine the usefulness of the budget as a fiscal
policy measure.  The generally cash-based federal budget deficit is
currently designed to provide an indication of the level of federal
borrowing.  Budget decisionmakers consider, among other things, the
effect of federal borrowing on the economy in general and the
national credit markets in particular.  If depreciation, a noncash
cost allocation, is recorded in the budget in lieu of actual cash
payments, budgetary decisions would no longer be connected to their
impact on the government's borrowing. 

We recognize that there are already departures from a cash-based
budget process when the cash basis fails to recognize the
government's full commitment up front.  Credit reform, for example,
is a revised method, specified in the Federal Credit Reform Act of
1990, of controlling and accounting for credit programs in the
budget.  It requires that the full cost of credit programs over their
entire lives be included in the budget up front so that the full cost
is considered when making budget decisions.  However, changes in the
treatment of the investment spending we reviewed would do the
opposite.  For such spending, departing from the cash basis of
budgeting by budgeting depreciation would actually spread the
government's commitment over time rather than recognizing it when it
is made. 

Finally, budget experts mentioned the difficulty of depreciating
assets that are not owned by the federal government.  Many of the
investment expenditures of the federal government are made in the
form of grants for assets or intangibles that the federal government
does not own.  There is currently no provision in any accounting
standard for depreciating assets that are not owned.  Grants are
normally accounted for as current expenditures. 

Despite the disadvantages cited in using depreciation for budget or
resource allocation decisions, there is widespread agreement in the
literature and among the budget experts and program analysts we
interviewed that depreciation can be a useful analytical tool for
certain other purposes.  For example, information on depreciation
costs may be one factor considered in making budgetary decisions by
serving as a reminder that aging assets may require replacement or
maintenance.  Depreciation may also be used to measure the operating
cost of an activity. 


--------------------
\6 In the Budget Enforcement Act of 1990, as amended, discretionary
spending refers to spending controlled by the Congressional
appropriation process.  Mandatory spending refers to relatively
uncontrollable payments for entitlements which are controlled
indirectly through substantive law rather than directly through the
appropriation process. 

\7 Under the Budget Enforcement Act of 1990, as amended, spending
limits or caps are the maximum amount of new budget authority and
outlays for discretionary appropriations. 


   INVESTMENT COMPONENT IN THE
   BUDGET
---------------------------------------------------------- Chapter 2:4

We have previously reported that depreciation is not a practical
alternative for the Congress and the administration to use in making
decisions on the appropriate level of spending intended to enhance
the nation's long-term economic growth.\8 While depreciation is used
in estimating the level of the nation's economic wealth, we believe
that these estimates are not useful in determining future federal
spending.  However, we have reported that an investment component in
the federal budget, with targets for appropriate levels of
investment, could be more useful to the Congress and the President
regarding decisions on future investments. 

Setting an investment target would require policymakers to evaluate
the current levels of investment and consumption spending and would
encourage a conscious decision about an appropriate overall level of
investment.  In our view, unlike a focus on incremental depreciation
charges, this approach has the advantage of focusing budget
decisionmakers on the overall level of investment supported in the
budget without losing sight of the unified budget deficit's impact on
the economy.  It also has the advantage of building on the current
congressional budget process as the framework for making decisions. 
And it does not raise the budget control and other practical
measurement problems posed by the use of depreciation. 


--------------------
\8 Budget Issues:  Incorporating an Investment Component in the
Federal Budget (GAO/AIMD-94-40, November 9, 1993). 


MAJOR CONTRIBUTORS TO THIS STUDY
=========================================================== Appendix I


   ACCOUNTING AND INFORMATION
   MANAGEMENT DIVISION WASHINGTON,
   D.C. 
--------------------------------------------------------- Appendix I:1

Christine E.  Bonham, Assistant Director
Warren C.  Underwood, Evaluator-in-Charge
Bruce L.  Baker, Evaluator

