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

the determination of the _present_, existing values in the asset. Under certain conditions fair depreciation corresponds roughly with actual or absolute depreciation as defined above. Complete and Incomplete Depreciation Depreciation is sometimes classed as “complete” and “incomplete.” Complete depreciation refers to those assets or properties which have been discarded because no longer capable of economical service. When their cycle comes to an end, depreciation is complete. Incomplete depreciation refers to the amount of the decrement in value of assets which are still in service. The accounting for complete depreciation requires little consideration except so far as _rates_ of depreciation are concerned. This class of depreciation represents the accomplished fact and therefore furnishes data and statistics by which the _expected_ depreciation of similar new assets can be calculated. The accountant, therefore, is concerned with it purely as an experimental means of forecasting the future. Individual and Composite Depreciation Again, depreciation is classed as “individual or unit” and “composite.” Unit depreciation is the amount of the decrease in value of the individual parts which compose the whole of a property; composite depreciation is the amount of the decrease in value of the plant or property as a whole. Its amount in dollars is the sum of all unit depreciations similarly expressed. Expressed as a percentage it represents the effect of all unit depreciations weighted by the ratio of the value of each to the whole. Thus a plant as a whole may be depreciated 20%, but the numerous units of that plant may have a range of depreciation of from 0% to 100%. Some items may be ready to be discarded and others will probably have just been newly installed. In connection with composite depreciation the term “normal” or “average” value is used. The normal value of a plant is the average value at which it must be maintained to give efficient service. Any drop below that point results in increased cost per unit of service rendered, and is consequently evidence of poor management. Normal value may sometimes be expressed in percentage as the difference between 100%, original cost, and composite depreciation. In the case cited above, where composite depreciation is 20% the normal value would be 80%, under a proper policy of management. Physical and Functional Depreciation Finally depreciation is classed as “physical” and “functional,” definition of which are deferred for treatment in Chapter VII, “Depreciation—Its Causes.” Deferred Maintenance and Accrued Depreciation Other terms needing definition are: “deferred maintenance” and “accrued depreciation.” The former refers to repairs which at any given time are needed for the proper up-keep but which for one reason or another have not yet been made. So long as an asset is giving reasonably satisfactory service, repairs are usually deferred to a convenient time—such as when work is slack, or until similar repairs may have accrued elsewhere, or until weather conditions have changed, or in general until the repairs can be most economically done. Similarly, accrued depreciation refers to the depreciation which has taken place between the last time an item was brought on the books and the present time. The inevitable forces causing depreciation are constantly at work bringing about the decretion of the asset day by day, but it is impracticable to reflect such condition daily. Only at the close of each fiscal period is it deemed necessary to adjust the books so that they reflect the depreciation which has taken place during the period just closed. Attitude of the Law Before studying the factors of depreciation it is interesting to note the attitude of the courts towards depreciation. Accountants and engineers recognized the necessity of taking account of depreciation considerably in advance of its recognition by the courts of this country. H. R. Hatfield[18] says: “France, Belgium, Switzerland, Germany, Austria all prescribe in their statutes that depreciation must be reckoned before showing profits.” The French Joint-Stock Company Law specifically requires the reservation of some portion of the company’s surplus for taking care of the depreciation of the assets. While the method may not be scientific, the principle involved is recognized as correct. But in an early English case, Lee v. Neuchatel Company, it was held, in the case of a company operating inherently wasting assets “that even depreciation by waste is not necessarily a revenue charge.” [18] In “Modern Accounting.” Early decisions in this country likewise fail to sustain the propriety of depreciation charges. The cases usually cited are The Union Pacific R. R. Co. v. United States, 99 U. S. 402, and United States v. Kansas Pacific Ry. Co., 99 U. S. 455 (1878), the first not passing specifically on the question of depreciation but showing a lack of appreciation of the distinction between capital and revenue charges, and the latter stating that “only such expenditures as are actually made can with any propriety be claimed as a deduction from earnings.” The Supreme Court of California in San Diego Water Co. v. San Diego, 118 Cal. 556 (1897), and in Redlands, etc., Water Co. v. Redlands, 212 Cal. 312 (1898), refused all allowances for depreciation except necessary amounts for “maintenance and repairs during the year.” However, in Pioneer Tele, and Tele. Co. v. Westenhaver, 118 Pac. 354, the language of the court is not uncertain: “A sufficient sum should be allowed from the earnings of a utility to make good the depreciation of the plant and replace the deteriorated portions thereof, when they become so impaired that they can no longer be made useful by repair.” Decision of Supreme Court The United States Supreme Court recognizes the necessity for an allowance for depreciation in Mayor and Aldermen of the City of Knoxville, Appt., v. Knoxville Water Co., 212 U. S. 14 (1909), which forms the basis of judicial attitude towards the question at the present time. The decision of the court which has been supported and reaffirmed in all subsequent decisions, reads, in excerpts: “A water plant with all its additions begins to depreciate in value from the moment of its use. Before coming to the question of profits at all the company is entitled to earn a sufficient sum annually to provide not only for current repairs, but for making good the depreciation and replacing the parts of the property when they come to the end of their life. The company is not bound to see its property gradually waste, without making provision out of earnings for its replacement. It is entitled to see that from _earnings_ the value of the property invested is kept unimpaired, so that, at the end of any given term of years, the original investment remains as it was at the beginning. It is not only the right of the company to make such a provision, but it is its duty to its bond- and stockholders, and in the case of a public service corporation, at least its plain duty to the public. If a different course were pursued, the only method of providing for replacement of property which has ceased to be useful would be the investment of new capital and the issue of new bonds and stock. This course would lead to a constantly increasing variance between present value and bond and stock capitalization—a tendency which would inevitably lead to disaster either to the stockholders or the public, or both.” Recognition of the Depreciation Factor Following this decision the rules and regulations of the public service commissions of practically all the states now require that provision for depreciation be made. In the case of some of the smaller public service companies the failure to make this provision is overlooked but the practice is generally recognized as absolutely necessary. The Interstate Commerce Commission has led in this respect, although its early rulings relative thereto were strenuously objected to in some quarters. Private concerns in their contact with the government now almost invariably see the value, or at any rate the self-interest, of a deduction for depreciation. In the case of the Special Excise Tax, a Treasury decision on account of Internal Revenue provides that “deduction on account of depreciation of property must be based on lifetime of property, its cost, value, and use, and _must be evidenced by a ledger entry_ and a like reduction in the plant and property account with respect to which depreciation is claimed.” Similarly, the present Federal Income Tax Law recognizes allowances for depreciation, but perhaps errs in placing too stringent safeguards on the amounts to be deducted therefor, whereas the Federal Trade Commission realizes the need of liberal provision. The law reads: “That in computing net income in the case of a citizen or resident of the United States, for the purpose of the tax there shall be allowed as deduction a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business or trade. No deduction shall be allowed for any amount paid out for new buildings, permanent improvements, or betterments, made to increase the value of any property or estate, and no deduction shall be made for any amount of expense of restoring property or making good the exhaustion thereof for which an allowance is or has been made.” The depreciation allowed as a deduction from income must have actually been charged off the books. Many interesting rulings—some almost absurd if carried to their logical conclusions—have been made by inspectors and the Treasury Department on points raised as to the application of the above law to particular cases. A perusal of these decisions will well repay the student who is interested in the subject. Distinction between Repairs and Renewals At this point attention is called again to the need of a careful distinction between repairs (up-keep and maintenance charges) and renewals (replacements and betterments). Only a clear definition of the terms and a strict adherence to an adopted policy can prevent endless confusion and absolutely misleading results. Such a policy is necessary because in the practical handling of such items on the books the theoretical aspect of the distinction between repairs and renewals must always be modified by reason. The student is referred to the preceding chapter where more detailed treatment of this point is given. Depreciation and Plant Efficiency The relation of depreciation to the efficiency of a plant or an asset will now be considered. The amount of depreciation is not based on the degree of efficiency of the service rendered by the asset. In other words, a depreciation reserve is not in any sense an inverse measure of the productive efficiency of the asset to which it relates, nor does the sum of all depreciation reserves either indicate or measure the degree of efficiency of the whole plant. A comparison of present with normal value (as defined above) affords some index of productive efficiency, but there is no direct ratio between the two. In any well-maintained plant, however, the normal value is the value below which the plant cannot be allowed to fall if the standard of efficiency is to be maintained; and good management requires nothing less than this. It has been variously estimated that normal value ranges from 75% to 90% of the original cost, and in some instances runs as low as 50%. The composite depreciation of from 10% to 50% represents the limit beyond which the decrease in value cannot pass if efficient service is to be given by the plant. Usually the sum of the depreciation reserves for all the assets of the plant remains fairly constant because the large reserves against assets that are almost ready to be scrapped are offset by the smaller reserves of the assets just replaced. Unit Efficiency The efficiency of the _unit_, however, has a somewhat different relation to depreciation. Units, i.e., individual assets comprising the plant, are constantly wearing out and being replaced. The plant, aside from exceptional cases, never reaches the point where it must be discarded in its entirety and replaced as a whole. The depreciation of each unit continues until the point of inefficiency is reached, when it is scrapped and replaced. The unit frequently is allowed to drop below its margin of efficient service before being scrapped, and it may be made to render service much longer than is customary, by means of heavy repairs and a relatively high up-keep expense. When to scrap a particular unit involves a nice calculation. The heavy cost of repairs necessary to secure good service from the old unit and the possible loss through failure to accumulate a sufficient reserve must be weighed against the cost of a new unit and its up-keep and running expense. Usually the efficiency of the individual unit is very like the parson’s one-hoss shay which “ran a hundred years to a day and then of a sudden it went to pieces all at once.” The following chart illustrates accurately the relation of efficiency to uniform depreciation, the XCY line being the efficiency curve and XY the depreciation curve. Also curve 6 of the chart on page 105 gives a good illustration of the same point. Inasmuch as the depreciation reserve must provide for the loss of the entire asset by the time it goes out of service, it is readily seen that in judging an asset from its bookkeeping record of cost and reserve there is no measure of efficiency shown therein, since a normal efficiency must be maintained by repairs at all times. The record is, however, a good index of the _time_ when the point of inefficiency will be reached. [Illustration: From “Principles of Depreciation,” by Earl A. Saliers. _Chart Showing Progress of Uniform Depreciation and of Diminishing Efficiency_] Engineers hold the opinion that machinery as a rule cannot suffer more than 25% to 50% _actual_ depreciation and give efficient service. A depreciation reserve of anything more than that does not mean that the point of inefficiency has been reached, for the reserve is usually estimated and applied on the basis of _theoretical_ depreciation and so takes cognizance of all its factors. It has sometimes been stated that inefficiency is a factor of depreciation distinct from wear and tear, obsolescence, and supersession. It seems a better statement of the relation to say that the point of inefficient service is the limit beyond which the three factors named cannot be allowed to operate or have effect. The need of judging the efficiency of some kinds of assets is not so apparent as of others. Thus in the case of poles, wires, conduits, and the like, efficient service is secured until they are worn out, with very little expense for up-keep. That is, such assets are normally efficient throughout their whole term of life, and the application of repairs will not appreciably extend their life nor will it affect their efficiency. In the case of other assets, such as machinery, telephone switchboards, motors, etc., the item of up-keep is a very vital one in the determination of the point or margin between efficient and inefficient service, and that in turn is an important factor in the determination of the length of service life of the asset. Thus, although efficiency and depreciation are intimately related, the degree of depreciation at a given time is not by any means an inverse measure of the efficiency of the service being rendered by an asset. Depreciation and Fluctuations in Market Value The relation of depreciation to fluctuation in value, due to whatever causes affect the market, also deserves consideration. Depreciation primarily refers to a decrease in value from a definite cost figure, such decrease being due to certain well-recognized causes, of which change in market value is not one. Thus, while it may be correct, through a loose use of the term, to use the expressions, “depreciation of securities,” “depreciation of real estate,” and similar phrases, and there may be no likelihood of any misunderstanding, that is not the sense in which the term depreciation is used here. Unfortunately, market fluctuations are sometimes allowed to influence depreciation charges. Such influence may come about in three ways: (1) In valuation proceedings for the determination of rates for a public utility company, a basis frequently used is that of the cost of reproduction or renewal less depreciation. The theory is that under existing views of private property such a company has the right to the enjoyment of all increments in its own properties and therefore has a right to such rates as will earn a fair income on the present value of those properties. Depreciation based on the present reproduction cost is in this way influenced by fluctuations in market value, and the oftener a physical appraisal is made and its determined values brought upon the books, the greater will be the disturbance of the basis for the depreciation charge. (2) Occasionally the practice is met with of basing the present depreciation charge upon the estimated cost to replace the old asset. This is discussed later and is mentioned here merely to show a possible relationship between fluctuations and depreciation. (3) Finally, in the _periodic adjustment_ of depreciation rates and charges, the estimated scrap value of the asset does affect the amount of the periodic charge. Changes in market value of scrap, which may be considered as due to causes which will continue in force rather than to the ups and downs of the market, may _legitimately_ be reflected in the depreciation charge for the remaining life-term of the asset and must be so reflected in the interests of accuracy in any statement of true values. Distinction between Depreciation and Depletion Inasmuch as depreciation is not here used to apply to current assets (with one exception noted below), and fluctuations in the market value of any asset subject to depreciation need not be considered, it may be well to state the class of assets to which it does apply. In general the value of all fixed or capital assets is affected by depreciation. The term frequently used in this connection is “wasting” assets. Under this nomenclature is included any asset which wastes away or is used up. For the sake of clarity the author desires to limit the term depreciation to those assets which are clearly affected by any of the causes of depreciation as discussed in the following chapter. For those assets which are used up without any possibility of their being replaced, and the life of which cannot be prolonged by repairs and renewals, the term depletion will be used. Accordingly the term “depreciation” will be applied to mine buildings and machinery; “depletion,” to the mine. Both are wasting assets, but their waste is due to somewhat different, although vitally related, causes. No better definition of wasting assets has been formulated than that by P. D. Leake[19] who says that they “consist of all forms of exchangeable value which inevitably diminish while applied to the purpose of seeking profits, increase, or advantage otherwise than by purchase and sale.” [19] In “Depreciation and Wasting Assets.” Effect on Different Kinds of Business Some types of undertakings are more subject to the effects of wasting assets than others. Concerns dealing in investments, insurance of all kinds, brokerage and commission, manufacturers’ agents, banking and financial houses, professional firms, and the like, only a small portion of whose capital is tied up in fixed assets, are comparatively unaffected by the charge for depreciation. Practically all other concerns are subject to it in marked degree—manufacturers, mines, transportation companies, light, heat, and power concerns, the telephone, telegraph, and cable, construction companies, agricultural, etc. Those engaged in extracting raw materials from the ground are, with few exceptions, subject to a charge for depletion. Those with an investment in any kind of terminating rights, such as leases, patents, copyrights, non-renewable franchises for a fixed term of years, and so on, are also subject to it. Opinions differ as to whether good-will and trade-marks may properly be considered as subject to depreciation. They will not be so considered here for reasons which will be stated when the principles of their valuation are discussed. It will be noted that thus far all examples given have been those of fixed assets. The exception already referred to is made in the case of the current asset, merchandise or stock-in-trade. The term depreciation can perhaps correctly be used in connection with merchandise, which, however, is not to be classed as a wasting asset. Due to some of the causes discussed in the next chapter, the stock-in-trade of an undertaking does truly depreciate in value. The method of accounting for such depreciation differs entirely from that used for wasting assets. Hence, the treatment of depreciation of merchandise will be considered at the same time that its valuation is discussed (see