Accounting theory and practice, Volume 2 (of 3) : a textbook for colleges and…

DEPRECIATION—ASPECTS AND DEFINITIONS OF TERMS Aspects of Depreciation Depreciation is intimately related to practically all problems of valuation. The engineering profession has made many valuable investigations and contributions to the literature of the subject and constant reference to them and use of some of their findings will here be made. Most of their studies relate to the vexed and still unsettled question of the valuation of public utility properties for the sake of its bearing on the problem of fair and equitable rates to the user or consumer. Accordingly much of this material is not applicable to the accounting phases of the subject. It is purposed here to treat the question from the standpoint of accounting rather than that of engineering. Depreciation may be considered from many viewpoints. It is involved in the problem of rate-making referred to above; it must be considered in the valuation of fire insurance adjustments; it is bound up with most questions of taxation, with all transactions involving the purchase and sale of enterprises, with negotiations for the procuring of loans, for the determination of the limitation of capitalization; and in all studies of commercial balance sheets depreciation is found to affect the value of going concerns. As stated in Chapter V, these are not always separate and distinct problems of valuation; they may and often do overlap, one basis for valuation sometimes serving several of the purposes or classes named above. The treatment of the subject will be limited in this book to the latter phase of the subject, i.e., going concern valuation, with the object of establishing certain norms and differentiating this phase of depreciation clearly from its other relations. Definitions A clear-cut definition of depreciation is desirable. The word in a general sense means a lessening, a decrease in value; decretion; deterioration. Various specific definitions are given, among them being: “the loss, arising from years of service, in the value of the investment in perishable property”; “expired capital outlay.” These and many other similar definitions are met with. The term “depreciation” is frequently used when the term “amortization” would be more appropriate. R. P. Bolton[14] says: “The subject of depreciation has been greatly misrepresented, because depreciation, which is a financial result, has been confused with obsolescence, which is an economic process, and with deterioration, which is a physical condition. Either of the latter brings about depreciation, and the physical process rarely happens to be more rapid than the economic. “An illustration of the processes involved is that of the physical deterioration and obsolescence of a work horse, the capacity of which is definitely connected with its condition, and the value of the labor of which is discounted by its up-keep and the cost of its supplies and feed. Its age is productive of reduction of capacity, but this process may be, and often is, anticipated for commercial reasons by its supersession by some other form of apparatus. The horse may be in ever so good a condition at the time when the motor displaces it, but its financial depreciation then is complete, for it could be maintained only at a loss. All the elements which come into consideration in connection with machinery will be better understood if considered in relation to such an animal, the life of which may readily extend beyond the point at which its commercial value has terminated.” [14] In “Power for Profit.” Authoritative Opinions The special committee appointed by the American Society of Civil Engineers for the purpose of formulating principles and methods for the valuation of railroad property and other public utilities, after a study of the question covering a five-year period, presented its report at the annual meeting of the society, January 17, 1917. The question of depreciation receives full and serious consideration in this report, which although treated mainly from the rate-making standpoint offers many suggestions for the valuation of commercial balance sheets. Their statement reads: “Perhaps there is no single subject in connection with valuation that has caused more trouble than depreciation. This has been due to various causes, perhaps not the least of which has been confusion in the use of the term. Depreciation is sometimes used to mean decretion, which is loss of service life; sometimes to mean the money allowance made in the bookkeeping to offset accruing loss of service life; and sometimes the loss of value existing at any time due to the loss of service life or any other cause. The committee will use it only as meaning the loss of value or worth of property units which are parts of going concerns. Although this may be due to many causes, the general discussion will include consideration only of those effects which, like wear and tear, age, use, and obsolescence or inadequacy, bring a physical property unit gradually to the end of its service life.” Earl A. Saliers[15] says: “This loss of value, whether tangible or intangible in form, resulting from physical decay, or from obsolescence or inadequacy, which indicate functional decay, is known as depreciation. It necessitates repairs, renewals, and replacements. Did it not occur, every outlay on plant would add to the investment. It does not result from one cause but from many causes, and this sometimes leads to the belief that it cannot be scientifically handled. But some adequate method of handling it is not merely desirable, but necessary, to a solution of the problems arising in the valuation of public utility properties, and in the management of industrial enterprises generally.” Henry Floy[16] says: “It (depreciation) is used broadly to mean a reduction in utility value, expressed as a percentage but more usually in dollars, due to any deterioration in physical plant by reason of: (a) normal wear and tear, (b) age or physical decay, (c) inadequacy, (d) obsolescence, (e) deferred maintenance. The term depreciation, always used in connection with a reduction in value, has, however, four distinct and separate shades of meaning, so that the term must be qualified when used in order to distinguish which one of the following meanings is intended: [15] In “Principles of Depreciation.” [16] In “Value for Rate-Making.” “First. The annual amount, expressed as a percentage or in dollars, that should be laid aside to renew or replace the article in question at the time of its abandonment. “Second. The annual amount, expressed as a percentage or in dollars, that should be laid aside to renew or replace the article in question at the time of its abandonment, plus the annual expense of maintenance and repair expended in removing such part of depreciation as is practicable and good economy. “Third. The total amount—usually that estimated as necessary to be expended to put the physical property in perfect operating condition—determined by the inspection and observation of an experienced engineer, expressed in a percentage or in dollars, which must be deducted from the ‘original cost’ or the ‘cost to reproduce new,’ in order to determine the absolute, actual, present value. “Fourth. The total amount—it may be the sum of several years of depreciation—computed from ‘expectancy of life’ tables, more or less authoritative, expressed in a percentage or in dollars, that must be deducted from the ‘original cost’ or the ‘cost to reproduce new,’ in order to obtain the theoretical, present, depreciated value. This value may be increased or reduced by the condition of the property, as determined from inspection.” The foregoing quotations from authoritative sources not only show the efforts made to define the term accurately, but also indicate the various elements included by different writers under the term, and suggest the need of further effort toward the standardization of its meaning. Why the Depreciation Factor Arises The distinction made in Chapter V between capital and revenue charges draws attention to the fact that the depreciation factor arises only because the fiscal or other period when information concerning values and costs, i.e., financial condition, is desired, does not coincide with the expiration of service life of the properties used in production. If the information just referred to were not desired at intermediate periods between the date of acquisition of the asset and the date of its discard or obsolescence, its cost should be treated solely as an expense of operation to be charged to the whole period in the same way that the fuel consumed, the raw materials used, etc., are regarded as revenue charges, or costs of manufacture. Practically, therefore, depreciation must be considered because a statement of financial condition is needed at regular stages of the life of the enterprise; and furthermore because the life of the various assets used in an undertaking is not uniform in length and their life histories in consequence overlap. Some assets wear out and have to be replaced, while others have still many years of useful service in them. Actual or Absolute Depreciation Before considering the various elements of depreciation, an explanation of some related terms will be given. A distinction is sometimes made between “absolute or actual” and “theoretical” depreciation. Absolute depreciation is the decrease in value of an asset from its state when new, to its present condition _as viewed either from the standpoint of the amount it could be sold for_ or from the standpoint of its serviceability. In the first place, therefore, absolute depreciation is not applicable to going concern valuations. A machine after only a short term of service becomes, from the standpoint of its salability, a second-hand article and suffers a large decrease in _market_ value. A water-pipe or an underground telephone cable immediately after its installation and even before it is brought into service depreciates materially from the standpoint of its salability as a disconnected unit. But from the standpoint of service and operations, i.e., adaptability to its intended use, such an asset may really be more valuable than before or immediately after installation. Again, an asset because of the excellent state of repair in which it is maintained may, so far as the serviceability required of it is concerned, be practically as good as new from the date of its installation until well along towards the end of its life-term. Its actual or absolute decrease in value is very slight during the early years of its life but increases rapidly just before it is discarded. This fact is illustrated by the example of the water-pipe. Slight repairs, the replacement of parts and small units, keep it for a long period 100% efficient, but the time comes when it is completely worn out and repairs are no longer economically advisable. These two examples illustrate absolute or actual depreciation. Theoretical Depreciation Theoretical depreciation is based upon, and has reference to, _all_ the factors which must be considered in taking account of depreciation. As so considered the subject is viewed from the standpoint of financing the item of depreciation (sometimes called “accounting depreciation”) rather than from that of its serviceability. The engineer attempts to determine the actual, present serviceability of the asset in comparison with its serviceability when new, and so he leaves out of account its expectancy of life due to whatever causes. Comparison of Actual and Theoretical Depreciation The following chart adapted from Henry Floy’s “Value for Rate-Making” admirably illustrates the difference between actual and theoretical depreciation. [Illustration: _Chart Showing Actual and Theoretical Depreciation_] Curves 1, 2, and 6 representing actual depreciation have been sufficiently exemplified in the foregoing explanation of actual depreciation. Curves 1 and 2 may well represent the actual depreciation of two assets as viewed from the standpoint of salability; whereas curve 6 represents the actual depreciation of an asset viewed from the standpoint of serviceability, assuming that maintenance has kept the asset practically 100% efficient during most of its life-term. Curves 3, 4, and 5 are illustrations of _theoretical_ depreciation, the different curves representing different bases for calculating the annual amount of the decrease in value, as will be explained in Chapter IX, “Depreciation—Methods of Calculating.” To quote from Mr. Floy’s work at length: “The curves 3, 4, and 5 indicate several classes of ‘theoretical’ depreciation which have been quite widely used in some cases for estimating present values, but more often for determining the yearly theoretical deterioration for purposes of establishing depreciation funds, which, however, is quite a different subject. Making a theoretical estimate of the probable, future, average, annually accruing deterioration of certain property to provide an item in bookkeeping accounts of operating expense has nothing whatever to do, in making an appraisal, with fixing the definite amount of absolute, actual, or accrued depreciation which depends upon the present condition of physical property, determinable from inspection and not upon historical documents, depreciation funds, or disputed theoretical conclusions.” In an opinion filed March 8, 1916, by the Public Service Commission of Maryland in the matter of the Chesapeake and Potomac Telephone Company of Baltimore City, an interesting commentary on the relative merits of actual versus theoretical depreciation is made. While the opinion concerns primarily depreciation from the rate-making point of view, it shows well the interrelation between the two kinds and answers so conclusively the objection often raised to accounting depreciation that it is here quoted. The statement is: “Any theory for ascertaining existing depreciation in the plant of a public utility which confines such depreciation solely to the actual, visible, physical, demonstrable deterioration which can be seen by the human eye and measured by the human hand, must of necessity ignore that other species of deterioration which the experience of the past has demonstrated beyond peradventure exists in the property of every telephone company, although it cannot always be seen by the human eye or measured by the human hand. We refer to that tendency upon the part of all such property to become inadequate or obsolete with the lapse of time.” “Accounting” and “Fair” Depreciation Another distinction is sometimes made between “accounting” depreciation, previously mentioned, and “fair” depreciation or depreciation of valuation. Accounting depreciation signifies the depreciation, determined by whatever method, which has been taken into the accounts, i.e., the depreciation as shown on the books. This is approximately the same as theoretical depreciation defined above. Its point of view is that of financing the loss of value caused by depreciation so as to cover the entire loss by the time the asset is retired from active service rather than that of establishing a true actual value of the asset at intermediate periods. On the other hand, fair depreciation or depreciation of valuation is the “sum that should be deducted from original cost to date (or from estimated cost of reproduction new)[17] as a step in finding that which the courts have called ‘fair value.’” Here the point of view is essentially that of showing the true value of the asset at a given date. Determination of this is fundamentally an engineering problem in the solution of which cognizance must be taken of: [17] Material in parentheses is the author’s.