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

(e) Insurance Method This method of carrying the depreciation charge is analogous to the policy practiced by some concerns of taking care of their fire losses by carrying their own insurance. If physical conditions are such as to make such a policy advisable or prudent, it should work out satisfactorily. It should be noted, however, that the insurance method is a means of providing funds for financing replacements and renewals rather than a method of insuring an equitable distribution of the depreciation cost over the product. The method of providing funds does not need to be the same as the method of measuring the periodic cost of depreciation. The insurance method serves the former purpose but is not well adapted to the latter. Much of the criticism of the sinking fund method is here applicable. (f) Percentage of Gross Earnings Method Measuring periodic depreciation as a percentage of the period’s gross earnings is a convenient and fairly satisfactory method under some conditions. If the principal element is wear and tear—a service factor rather than a time factor—output may have a very direct relation to gross earnings. If the commodity dealt in is a standardized product and its price does not fluctuate to any extent or, better still, is fixed, gross earnings will be a very fair measure of output. It is true that the estimate is based on a sales valuation of output rather than its cost of manufacture, but under some conditions this is a good measure of relative output as between periods. A depreciation charge based on gross earnings may thus give an equitable distribution of the depreciation burden. In the case of public utilities, when the price of the commodity or service dealt in is fixed, an estimate based on gross earnings usually gives satisfactory results where used. In applying the method, the expected earnings during the composite life-period of the plant are estimated and depreciation costs are then prorated over periods on the basis of earnings for the period as compared with total earnings for the composite life-period; or more simply, a fixed percentage based on past experience can be applied to the earnings of each period. Some objections to the method, arising in some cases from a misunderstanding of its operation, were pointed out when an explanation of its working was given. In some cases gross earnings bear no relation, or only the remotest, to the quantity of output or the units of service rendered. A depreciation estimate based on earnings would not in that case be logical and could not give satisfactory results. From the above discussion of some of the merits and shortcomings of the various methods, the cogency of the introductory remarks, to the effect that no method of measuring depreciation can serve as a panacea, should be appreciated. Every depreciation problem is more or less an individual problem; sweeping generalities will not serve. Effect on Return on Investment Many interesting studies have been made of the effect of some of the above methods on stability of income as between periods and their effect on the return of the investment, using hypothetical data as to the earnings of the depreciating asset. Except for the purpose of fixing rates in the case of public service corporations, where the public has an interest because of the monopoly granted, stability of income should be subordinated to the fact of depreciation and not serve as a test of the merit or demerit of a method.