How Courts Treat Depreciation That Affects Child Support

Generally Accepted Accounting Principles (GAAP) for Depreciation


The Labar Standard for Child and Spousal Support

It is disheartening to see that though there exists a widely accepted and almost exclusively used system of accounting for depreciation — GAAP (Generally Accepted Accounting Principles) — the courts have attempted to develop a separate method of addressing depreciation for the purpose of calculating child support. The methods approved by GAAP are designed specifically to present the most fair and accurate representation of the financial position of a company. By disregarding these principles and developing its own method, the court is saying to all accounting professionals that these methods are not legally acceptable by the court and will not be used to determine what the court asserts to be the actual financial status of the company. If the methods promoted by the Financial Accounting Standards Board (FASB) are acceptable (and sometimes required) by the Internal Revenue Service (IRS) and the Securities and Exchange Commission (SEC), among others, why then are they not suitable for use in the courts of the Commonwealth of Pennsylvania for the purpose of child and spousal support.

The courts have stated in their opinions that depreciation must be reevaluated in each case in order to arrive at the 'disposable income' of the individual. In order to reach this new figure, the court examines the appropriateness of the capital expenditure and the marginal tax benefit of the depreciation to determine if the capital expenditure was made to shield the party's actual income, Labar v. Labar , 557 Pa. 54, 731 A.2d 1252. The explanation of GAAP principles to follow will explain how the depreciation recognized by a company does not serve as a shelter for income in as much as it serves to recognize the inherent expense of running a business. Income is in no way understated by depreciation; income is overstated without it.

To understand the generally accepted accounting principles (GAAP) view of depreciation, it is first necessary to look at three of the fundamental principles of accounting: (1) cost (2) matching (3) systematic and rational allocation.

1) Cost — The cost principle of accounting, dominant in the United States, mandates that assets be recorded on the company's books at the amount paid for the asset. Generally, no attempt is made to reflect changes in market value. For example, a firm which bought land in 1925 would be carrying that land at its original 1925 cost on the 2002 balance sheet, even though that land is likely much more valuable in 2002.

2) Matching — The matching principle of accounting implies that expenses necessary or consumed in the production of income should be recognized (i.e., appear on the income statement) in the same period as the revenue to which they relate. For example, a retailer who rents retail space would show the rent expense for the month of September on the income statement for that month, regardless of when the rent was actually paid in cash.

3) Systematic and rational allocation — This principle implies that the using up of an asset over time should not be recognized as expense in an illogical or arbitrary manner. Rather, the expense should be recognized ratably over time. For example, a business that pays in advance for a three-year insurance policy would logically expense that policy at the rate of 1/36th per month, regardless of when cash is remitted for the policy.

GAAP depreciation is based on these three principles. When an asset is purchased, the amount paid is capitalized (charged) to a long-term asset account on the company's balance sheet, as required by the cost principle. An estimate is made as to the expected useful life of the asset. The matching principle dictates that the amount paid for the asset should be expensed over the period in which the asset is used to produce income. The systematic and rational allocation principle dictates that the expensing be done in a logical rather than arbitrary manner. For example, a machine purchased for $21,000 having an expected useful economic life of 7 years could logically be expensed at the rate of $3,000 per year.

As with any method of tracking income, there are instances where figures can be manipulated to benefit either party in a dispute. This should not imply, other than in cases of blatant misuse of the principles explained, that the depreciation expense recognized by a company does not represent an actual expense incurred by the business in its regular operation. The courts, in these cases, should recognize the process by which these rules have been made and the purpose they serve in portraying the finances of a business before changing the income of a company or individual, unless there is evidence of inappropriate behavior on the part of the operators of the company.

The method discussed and implemented by the court uses a cash flow based method of finding income — which in accounting does not, in most cases, accurately depict income — at the discretion of the judge. This method and the relative application explained in Labar v. Labar would make it more beneficial for companies to borrow all of the cost of capital expenditures and create interest expense to offset the dismissed depreciation expense rather than reinvest earnings. The court states that, "Only by asserting that the capital expenditures, for which depreciation deductions are currently being claimed, were made with cash flows that should have instead been disbursed to the shareholders, can it be argued that corporation is improperly sheltering cash flows" Labar v. Labar, 557 Pa. 54, 731 A.2d 1252, implying that the decision to reinvest capital into the business is a subjective one, open to scrutiny by the courts and others outside the business. To avoid this subjective examination of business practices the courts must begin using a standard method based on the guidelines established by the accounting industry that would be equitable to both sides of an argument. The interest of persons involved in child and spousal support cases cannot be said to be greater than that of the thousands of investors and government officials who rely on the financial statements prepared using GAAP in determining the financial situation of a company. As such their interests cannot be said to warrant a separate method of calculating depreciation. The solutions to this problem may be as simple as using a standard straight-line depreciation for all capital expenditures or as complex as the depreciation systems approved by the IRS; in either case the system must be standardized to eliminate the uncertainty inherent in the process as it is currently applied. In either case, it must be maintained that though the depreciation may be adjusted to reflect a more appropriate figure for net income, it may never be wholly and subjectively ignored when determining that income.

By: Robert Depasquale, Ph. D., C.P.A., C.M.A., C.F.M.

Eric E. Bononi, C.P.A., Esq.

Charles D. Scholz

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