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

Though much has been written about the causes and kinds of depreciation, the necessity of considering it, and methods of calculating its amount, so far as the author knows there has been no adequate presentation of the fundamental purpose of the depreciation charge viewed _both_ from the valuation or balance sheet point of view and the operation or profit and loss standpoint. The statement is frequently made that the purpose of depreciation and the necessity for considering it is to maintain intact the value of the original capital invested. In so far, therefore, as this necessitates a periodic charge against revenue, resulting in a retention in the business, either in a specific or floating form, of some of the revenue-producing assets, the operating or profit and loss phase of the business is affected. This secures the integrity of the original fund of capital by making the revenue receipts unavailable for distribution among the stockholders until the portion of the assets wasted away has been made good. This view of depreciation has as its actuating purpose a showing of correct values in the balance sheet, with little regard to the purposes to be served by the depreciation charge against operations. This emphasis of the problem of valuation is usually looked upon as primarily the engineering viewpoint. Depreciation a Cost of Operation On the other hand, many students of the problem view the depreciation charge as incurred for the sole purpose of determining the correct costs of doing business. Unquestionably, depreciation is a cost of production. A portion of the service life of equipment goes into each unit of the product, and depreciation constitutes a cost which must be borne by the product with as much reason as the labor power that fashions and forms it and the raw material out of which it is made. To determine a cost of production and a profit without the inclusion of the depreciation charge would be, as R. H. Montgomery[26] says, just as logical as “to state that a candy manufacturer had earned a net profit of $100,000 and that out of said $100,000 there had been set aside $20,000 to pay for the sugar consumed in the manufacture of the product. The use of that which is consumed is a loss or expense. Machinery is consumed; sugar is consumed. You cannot say that one is an operating expense and the other is an item which need not be ascertained nor taken into account until the net profit is shown.... If the provision for depreciation is an item which cannot be included among the costs of operation, there is something wrong.” [26] In “Income Tax Procedure, 1918.” This view of depreciation attempts to show the correct costs in the profit and loss statement of operations, without much regard to its effect on the balance sheet except that, in so far as every charge against operations is reflected among the assets, the fact of its inclusion as an operating cost automatically works also as a means of declaring correct values. Under this view—which may, without any misstatement perhaps, be called the accountant’s viewpoint—the emphasis is placed on the effort to show true costs of the product, and only incidentally a true valuation of the assets. Complication of Short Fiscal Periods Theoretically there is no conflict of views here—only a difference in emphasis. It is purposed, however, to show some of the practical difficulties encountered in the full application of either view. As has been stated in an earlier chapter, the ideal time in so far as depreciation is involved for the determination of financial results would be the time when all the elements of production entering into the product have been completely used up—if this were possible. There would then be no troublesome problems as to inventories, accruals, or deferred charges. The fiscal period would coincide with the natural service-life periods of all the producing elements. The problem of depreciation would then be a simple one, and the entire value of the equipment would be a charge to the product turned out during its life-period. Such a method of determining the financial results of an enterprise is, of course, merely fanciful. There is always, and will be always, an overlapping of the life-periods of the various units of a plant. Furthermore the practical necessities of modern business and competition require a much shorter fiscal period with a more frequent figuring of results and showing of condition. It is due to this shortening of the fiscal period to one month, six months, or a year that the difficulties of the depreciation problem arise and inaccuracies of statement are consciously or unconsciously made. The handling of the problem hinges on the answer to the question as to the correct basis for the distribution of the depreciation charge. Shall a fiscal period of arbitrary length be used as the basis for determination of the service life of the operating equipment? Or shall the life of inanimate equipment be measured in terms of units produced, service rendered, results achieved, just as human life and age may be measured in terms of intensity of thought and action? It is unfortunately true that once the depreciation charge is settled, this same charge is constantly applied with little adjustment to changing conditions. Thus, varying intensity of service is not reflected in the periodic charge. The Factor of Idle Time Were it possible to foretell length of service life in terms of units of product instead of units of time, a much better approximation to actual results would be secured. And this very thing is _attempted_ under almost all methods of estimating depreciation. The life-period of the equipment is estimated on an assumption of _average_, _normal_ use of the equipment—an assumption which will give good practical results when and so long as operations are normal or average. When, however, a period of depression comes and much of the equipment is idle, it is clear that that period would be burdened unduly with a depreciation charge based on _years_ or _months_ of service life. On the other hand, a period of feverish activity would not bear its just share of the burden of wasting assets. The period which is really overburdened must necessarily reflect it as an undervaluation of the assets—more has been charged off than has been used up; while the opposite is true of an underburdened period. Of course, on the theory of averages, by the end of the life-period of an asset all inequalities would be ironed out. Some methods of cost-keeping take this factor of intensity into account and spread the depreciation charge on a man-hour or machine-hour basis, which proportions it somewhat equitably to the product turned out by the use made of the machine and not to its elapsed life in days or months. The best that can be hoped for is as near an approximation to the truth as possible. Depreciation a Means of Financing Another view of the purpose of the depreciation charge is that it is a method or means of _financing_ depreciation as it is sometimes termed. Under this view the effect of the depreciation charge on intermediate periods is lost sight of and it is used solely as a means of securing a sufficient contribution in hand _at the end_ of the service life of the asset to finance its replacement. In other words, no attempt is made through the periodic depreciation charge to secure an accurate or necessarily true statement of the values of the assets, nor to see that the product of a given period is burdened with its just share of _all_ costs, though this may be an incidental purpose. H. V. Hayes[27] in discussing this phase of depreciation says: [27] In “Public Utilities, Their Cost New and Depreciation.” “It is argued that the plant unit ‘deteriorates’ year by year and that this ‘deterioration’ is the true measure of the ‘depreciation’ in the value of the unit during the intermediate years of its life, and, being a physical condition of the plant, can in no way be measured by the purely financial considerations upon which the reserves for depreciation necessarily must be based. Such a line of reasoning is absolutely faulty. Any attempt to reconcile ‘deterioration’ with ‘depreciation’ at any intermediate period in the life of the plant of an undertaking, is not only unnecessary but futile. The error in such an attempt arises from a failure ... to recognize the fact that ... if definite agreement has been reached as to the serviceable life (of the asset), the physical ‘deterioration’ of the unit, at any time during its life, can be a matter affecting its intrinsic value in no way whatever.” Danger of the Financing Viewpoint The above statement is a fair presentation of the case for depreciation as a financing device. It would seem, however, that the exponents of this view lose sight of the inevitable fact that the depreciation charge is _pro tanto_ an evaluator of the wasting asset during the intermediate period of its life. Therefore a logical conclusion to be drawn from the view as expressed in the quotation above, would be the countenancing of any method by means of which provision could be made to replace the asset by _the end_ of its life, no matter whether the charge was spread evenly over its life, was made all in one year, or was made to depend on the amount of the net profits at the end of a given year. This latter alternative is a dangerous policy, always to be deprecated, for depreciation is a cost of production to be taken account of _before_ profits can be determined. After all, it may be said without fear of serious contradiction that all three views, i.e., the engineering, the accounting, and the financing viewpoints, must be held in mind in any adequate treatment of the depreciation charge. The important point from the commercial and accounting standpoint is to secure a fair and equitable charge to each unit of product, regardless of whether or not the burdens of each fiscal period are equal. This is particularly evident when wear and tear from use is the _effective_ factor in depreciation—and it is also contended that the factors of obsolescence and inadequacy may be as successfully and relevantly estimated in terms of business output as in years. If this results in an accurate valuation of the asset—and it is conceded that from the engineering viewpoint it may sometimes so result—the inaccuracy is of minor importance. According to the general law for the valuation of fixed assets, changes in the market need not and should not, as a general thing, affect the values at which the assets are carried on the books _of a going concern_. It is, of course, a corollary to the main proposition that this treatment also makes adequate provision for financing the fact of depreciation. Various methods and means for the accomplishment of these purposes are given in