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

General Considerations In a discussion of compound interest methods the basic feature, that of the compound interest principle, requires consideration. The thought of progression on a compound interest basis is fascinating to many. It is a powerful instrument of accumulation and its charm seems to lie in the fact that through its instrumentality small sums can be made to grow into large sums. Whether the principle is applied to the creation of a fund or simply as a method of _calculating_ periodic amounts, the remarks of P. D. Leake,[36] an English authority, are equally appropriate. He says: “May I impress upon you that these devices are dangerous expedients in any but the most skillful hands.... It (the sinking fund) is apt to give a sense of false security, because its whole virtue depends upon its obligations being faithfully carried out over the whole period, and this condition is not always fulfilled.... It is probable that in many cases the use of a sinking fund is an altogether unwarrantable draft upon the future, because there is no reasonable certainty that the fund, whether it be state, municipal or commercial, will not be raided before it attains its object.” [36] In “Depreciation and Wasting Assets.” Over short periods the difference between the periodic amounts under this method and the straight line method is slight, as will be apparent from a comparison of the two charts on pages 153 and 162, giving graphic illustration of the two methods. There the period is for five years. When the period is extended to, say, twenty or fifty years, the difference in burden, due to interest accumulations, between the early years and the later years is very marked. “Thus, a 10-year unit having no salvage value, loses half its value in 5 years under the straight line theory, regardless of the rate of interest, and at 5% under the compound interest theory it loses nearly as much—about 44% of its value in the same time; ... but a 50-year unit, losing half its value in 25 years, under the straight line theory, loses only 22.8% of its value, at 5%, under the compound interest theory.” (a) Sinking Fund Method The sinking fund method as an orderly scheme for estimating the periodic depreciation charge _will_ make the estimate, and, if adhered to faithfully, the entire depreciation will be written off by the end of the service life of the asset. In this respect it is to be preferred to any arbitrary or haphazard method. That it secures an equitable distribution of depreciation costs over the product of the various periods, or that it effects a correct valuation of the asset at intermediate periods of its life is open to serious questioning. The periodic charge under the sinking fund method perhaps bears no relation to the fact of depreciation. The method is, at the best, simply a mathematical device for an orderly calculation of periodic amounts. In the valuation work of public service companies or in regulation work where, as in California, actual funds must be set aside to accumulate at compound interest, there is no serious objection to the method. Although it rests on false or doubtful assumptions of fact and results in an inequitable burden on the product as viewed from the standpoint of individual assets, these are minor considerations; for the method does by the end of its service life take care of the loss in value. Judged from the standpoint of its relation to up-keep costs, the method lays an increasingly heavy burden on the later years of the life of the asset. (b) Annuity Method All that has been said with regard to the sinking fund method applies with equal point to the annuity method. As previously indicated, in the explanation of its essential features, this method automatically secures a charge for interest on the investment as a part of the depreciation charge. Not only is the charging of interest of doubtful propriety in itself, but certainly its inclusion under the title of depreciation is misleading and indefensible. The courage of one’s convictions with regard to interest as a part of cost should not allow interest to shelter itself under the cloak of “depreciation.” By referring to the appraisal schedule and chart, it is seen that the real depreciation charge is exactly the same under the annuity as under the sinking fund method. (c) Unit Cost Method The unit cost method represents an attempt to secure an equal burdening of each unit of product with interest, depreciation, and operating costs. In the language of its proponents, “this theory is probably the soundest theory of depreciation, and when applied with intelligence, probably furnishes the truest measure of accrued depreciation.” While the end sought by the unit cost method is commendable, it is a compound interest method and it mixes interest, up-keep, and depreciation under the one title “depreciation.”