Forthcoming JRER Paper

The Straight-Line Depreciation is Wanted, Dead or Alive
 

Abstract:

Depreciation is a major item on the income statement of many real estate entities. We propose a simple axiomatic system that any depreciation method—complying with the core of the accounting of depreciation—must obey. The system is consistent with both the matching principle and the impairment-free property. We show that none of the prevalent depreciation methods (e.g., straight-line) ex ante conforms to these principles. We then examine the accredited proportional depreciation method under which an asset's periodic depreciation is determined pro rata according the ratio of each period's operating income to the asset's total operating income (in present value terms). We show that the proportional method not only maintains the axiomatic system, but also, following Moulin (1988), for a plausible family of depreciation methods, is the unique method that complies with the axiomatic system. Finally, we propose two consistency requirements of a depreciation method—partition consistency and dynamic consistency—and show that, in contrast to the commonly used methods, the proportional depreciation method is the only one to always sustain both. Our analysis may provide further resolution to the arguable evidence on the dominance of Funds From Operations over net income in measuring performance in the real estate industry (and REITs in particular).