To Depreciate or Not to Depreciate

The Antiplanner has previously argued that Amtrak uses “accounting tricks” to make the Northeast Corridor appear profitable and the system as a whole appear to cover most of its operating expenses out of revenues. The most important of these tricks is that it appears to count maintenance as a capital cost. As a 2001 Congressional Research Service report noted, “Under generally accepted accounting principles, maintenance is considered an operating expense,” but Amtrak excludes it when it compares operating revenues and expenses.

Recently, I met with an Amtrak official who explained that the situation is a little more complicated than I described. Historically, he said, railroads had counted maintenance against revenues when calculating their bottom lines, but this led some railroads to defer maintenance in order to improve their apparent profitability. As I understood his explanation, the Interstate Commerce Commission corrected this several decades ago by changing the accounting rules so that maintenance would be included in capital costs. This eliminated any incentive to defer maintenance.

I sort of understood that, but I’m not an accountant, so I looked up the history of ICC accounting rules. The best explanation was in a 2007 paper in the Accounting Historians Journal called “The End of Betterment Accounting.”

The paper notes that in the nineteenth century, railroads capitalized improvements but simply “expensed” (counted against operating costs) maintenance. For example, building a rail line was a capital improvement; replacing worn-out track on that rail line was a maintenance cost. If the new track was better than the old (for example, by being heavier), the added cost of the improvement was called a “betterment” and capitalized, but the basic cost was maintenance. This is called betterment accounting.

In 1906, Congress gave the Interstate Commerce Commission the authority to require railroads to use uniform accounting methods. This was designed to protect investors and help the ICC set rates. Commissioners worried that betterment accounting did not reveal the true costs of running the railroad, partly because maintenance–unlike other operating costs–doesn’t remain consistent from year to year and partly because railroads would tend to spend less on maintenance in lean years.

So in 1907 the ICC proposed to require railroads to treat maintenance using depreciation, when was then a relatively new accounting tool. If in a particular year actual spending on maintenance and capital improvements was less than was counted as depreciation, the railroad could bank the difference so it would have the money when it needed to spend more on maintenance. Since actual maintenance costs would not affect the railroad’s bottom line, it would have no incentive to defer maintenance.

The railroads opposed this proposal partly because they didn’t want to go to the trouble to make the change and partly because they feared it would make it more difficult for them to convince the ICC to let them raise rates when they needed to. In response to their protests, the ICC decided to require them to depreciate equipment such as locomotives and cars, but not tracks and structures, even though the track and structures made up the vast majority of their assets. Railroads had pioneered management and accounting techniques, but–thanks mainly to the rigidity of ICC regulations–railroad accounting was soon archaic.

In the 1950s, under its managing partner Leonard Spacek, the Arthur Andersen accounting firm began to demand that its clients comply with what it considered to be “ethical” accounting methods. Among other things, Spacek asked the ICC to update railroad accounting standards, which he said overstated railroad profits by as much as 50 percent. Spacek also refused to work for companies that wouldn’t accept his accounting methods, which meant he only accepted two railroads as clients.

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One of the reasons for the 1970 Penn Central bankruptcy was that the railroad used ancient accounting methods prescribed by the ICC that failed to tell its managers just which parts of the railroad were profitable and which were not. This led to pressure to deregulate the railroads, which finally happened in 1980.

The deregulation took away the ICC’s authority to set rates, but let it keep the authority to set accounting standards. Since railroads could no longer object that improved accounting might influence ICC rate setting, the ICC passed a rule requiring depreciation accounting for track and structures in 1983.

In reviewing this debate in 1981, the General Accounting Office endorsed depreciation accounting. However, it disagreed that this had anything to do with deferred maintenance.

With regards to profitable railroads, the GAO’s opinion on this issue seems to be in the minority. However, when it comes to money-losing operations, it is correct. One of the main points of depreciation is to build up a cash balance in years of low maintenance needs that will be available when more maintenance is necessary. But in the case of perennial money-losers like Amtrak and most transit systems, there are no surplus revenues to save. Thus, depreciation accounting won’t prevent deferred maintenance.

The Washington Metro rail system, for example, is a perfect example of deferred maintenance even though the Federal Transit Administration requires transit agencies to use similar accounting techniques. Amtrak itself admitted in a 2010 report that, as of 2007, it had $5.2 billion worth of deferred maintenance in its portion of the Northeast Corridor (see page 10), plus another $3.2 billion worth of deferred maintenance on the portion of the Northeast Corridor owned by the state of Connecticut (page 9).

Instead of using depreciation accounting to insure that its tracks are well maintained, Amtrak uses it to pad its bottom line–by ignoring it. As the Congressional Research Service report that I previously cited states, “in reporting its annual operating expenses–or more specifically, its shortfall in covering its annual operating expenses–to the Congress, Amtrak has excluded two types of expenses that GAAP defines as operating expenses: depreciation, and progressive maintenance.” By excluding these, such as when it recently claimed to have “the lowest operating loss ever“–Amtrak understates its losses.

Is this an accounting trick or is Amtrak just following the rules? If it were following the rules, it would deduct depreciation from its operating revenues when calculating its net. In fact, it does exactly that in tables buried deep in its financial reports. But in its press releases, it plays the trick of ignoring depreciation.

This is an important issue because conventional wisdom inside the beltway is that Amtrak’s Northeast Corridor is profitable, while the rest of the Amtrak system is not. Fiscal conservatives therefore argue that the Northeast Corridor should be privatized; fiscal liberals argue that taxpayers should pay to improve it (which first requires maintaining it). In fact, when all costs including maintenance and depreciation are counted, the Northeast Corridor is as big a money loser as the rest of the system, and it is difficult to justify the billions that will have to be spent to keep it going.