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

and the actual value of the holdings of the owners thus be enhanced. In the third case present dividends may be sacrificed for the sake of the future. Such reserve profits must be kept and used for the intended purpose, the purpose dictating their form as liquid or fixed. It cannot be too strongly emphasized that these are reserves of _profits_—not valuation or offset accounts under the title of reserves. Depreciation reserves, except they become secret reserves in the sense referred to below, have no right to serve any other purpose than that intended, viz., to provide insurance that none of the originally invested capital shall be dissipated and that the current product shall be burdened with its just share of _all_ the materials and costs of production. Secret Reserve A great deal has been said about inaccuracies in the depreciation charge; the need of periodic readjustments has been emphasized. Now it is purposed to look into the effects of inaccurate charges remaining unadjusted on the books. In a desire to be on the safe side, some concerns, notably financial institutions, make very liberal provision for depreciation. Such a policy is not entirely to be condemned and is decidedly refreshing in comparison with the parsimonious allowances, begrudgingly made in some quarters. The effect of such a policy, if operated without check, is to create what is known as a “secret reserve.” The value of the asset is charged more rapidly against operation than the asset actually wastes. Hence the books show a reserve sufficient to cover the cost of asset while there are still values remaining in the asset. In other words, the business possesses an asset of value which is carried on the books as of no value. Were the real present value of the asset brought on the books, the contra credit would appear in some surplus or _profits_ reserved account. Such would constitute a true record of the item, openly stated. So long as the asset remains concealed, i.e., without record on the books, its contra credit is also latent and constitutes a _secret_ reserve of profits. A too liberal depreciation policy, if recognized and adjusted at the time of a reappraisal, will require a separation from the depreciation reserve of the portion brought about by the overallowance, and its showing as a part of the surplus. When so handled, an overcharge for depreciation has no permanently bad effect except as it may show, for purposes of comparison, too high costs of production for the period overburdened. However it may be and sometimes is, used for purposes of fraud and therefore, as a fixed policy, the practice of the secret reserve is to be condemned. Insufficient Charge On the other side is the parsimonious policy of too low a charge or none at all. This results, whether consciously or not, in a charge against capital instead of revenue. At the close of the fiscal period the books are supposed to be brought into accord with the facts of true condition as then existing. Therefore, if the full portion of the accrued expenses is not separated from the wasting asset accounts, but is allowed to stand on the books under the title of assets, then these true expense items will still be carried hidden under the cloak of asset titles. The depreciation is thus carried as a charge against capital. The depreciation of a _going_ concern should never be so treated; it is an operating charge, and no flight of fancy or shuffling of figures can make anything else of it. In the case of a property, showing inflated values because of too low depreciation charges in the past, which is taken over and rehabilitated, the sums spent on the property previous to operation to put it in condition are properly capital charges. This is allowed on the theory—unfortunately, not always a fact—that the difference between the book value of the property and what was paid for it represents the estimated expenditures necessary to bring the property up to its book value. If such is not the case and full book value was given for the property, the charge is still allowed, being looked upon as in the nature of an organization expense, representing in an instance of this sort the measure of the bad bargain made. This will, of course, result in a penalty in the form of an added depreciation burden on all product from the property taken over and rehabilitated. Appreciation as an Offset to Depreciation If depreciation is so inevitable and the necessity of its charge so absolute, can anything be said in support of the proposal to offset depreciation against appreciation? By appreciation is meant an increase in value due to the passing of time. Judicial authority can be found in support of it in cases of valuation for rate purposes.[42] There is no question but that a _realized_ increment in land or any other asset offsets a depreciation or any other expense charge in just the same way that any other item of income offsets an expense. There is, however, this marked difference between depreciation and appreciation: the former is an inexorable reality advancing day by day entirely independent of market fluctuations, whereas the latter is dependent on the market and usually cannot be realized until the asset is sold. [42] See Consolidated Gas Co. v. City of New York, 157 Fed. Rep. 855, and 20 I. C. C. Rep. 344. When, however, as is too often the case, the proposal to offset depreciation by appreciation is meant to justify a policy which takes no cognizance of depreciation on the books because it is offset by appreciation, no support can be found for that view. In itself it reveals an entire lack of knowledge of the purpose of the depreciation charge or a disregard of the fundamental and obvious requirements of prudence. Depreciation is one of the costs of production and without it true cost cannot be shown. Failure to show depreciation on the books would justify also the omission of a cash income item because the cash was to be spent immediately in payment of salaries—a cancellation outside the business records of income against expense which can under no circumstances be justified. Appreciation Due to Physical Changes There is a kind of appreciation which is not dependent on fluctuations of the market and which as surely accrues, up to a certain point, day by day as does depreciation. Properties the value of which has been enhanced by earth construction work done on them are susceptible of this kind of appreciation. “Appreciation is generally restricted to physical items, and measures their gain in value due to age, use, and properly directed labor.... It results from work not specifically charged to capital account ... and covers items not represented ... in connection with a valuation.”[43] It is found in connection with such items as roadbeds, solidification and grassing of slopes, drainage, dams, embankments, etc. [43] Valuation Committee of the American Society of Civil Engineers. Its two forms are called solidification and seasoning, and adaptation. By the first is meant a settling and compacting of loose earth and its protection from wasting and washing away, as by the grassing of slopes, and the planting of trees and shrubs to hold the snows. When a roadbed is turned over to the operating division, it frequently is far from complete in the sense of being in a high state of efficiency, and the cost of its maintenance and up-keep during the early years of its life is much higher than during later years. This appreciation due to seasoning is difficult of valuation, but perhaps the difference in up-keep between early and later years is the best measure of it. Appreciation Due to Adaptation to Use “Adaptation” is a term used to cover that class of expenditures needed for the better adaptation of the property to its use. In the early stages of the development of a property many things cannot be foreseen nor can a proper basis be settled upon for a determination of the charges as between capital and revenue. The proper handling of such expenditures as those incurred for drainage requirements, better adaptation of the roadway to the surrounding topography of the country, etc., are difficult. If these costs have not originally been charged against capital, the properties may truly be said to have appreciated in value by reason of them. Items of this kind require a wise discrimination between costs of operation and capital charges. The effect of such changes is almost always lost sight of so far as physical appearance shows, and the appreciation due to them is difficult of valuation at a later time. In the case of railroads, perhaps the difference in maintenance cost as between the early and later years of the roadbed is the best index. In the case of industrial concerns, the cost of a rearrangement of machinery and working facilities for the better and more economical handling of the product frequently results in an appreciation in value due to adaptation to use. This has already been discussed in Chapter V. As stated above, appreciation has judicial sanction and its valuation, although fraught with many difficulties and uncertainties, has been made and the results accepted. The generally haphazard method of roughly estimating the value of an appreciation when its determination becomes necessary suggests that it were better, by far, to attempt the proper segregation of the charge between capital and revenue at the time of its incurrence, rather than to take cognizance of an appreciation in value at a later time. There are undoubtedly circumstances in which appreciation in value can be properly recognized and should be taken into the accounts not only of public utility properties but also of industrial concerns. Unearned Increment Appreciation in value due to so-called unearned increment is entirely a matter of market value. By this is not meant that the monetary value of this kind of appreciation fluctuates with the market; it accrues from day to day and is just as real as depreciation. Although very real, it does not become _realized_ until the property is disposed of, a thing which is determined by business policy and does not rest on any principles of accountancy. It is not good practice to bring such unrealized values on the books. For a fuller consideration of this phase of the subject, see Chapter XVII where the problem is treated in connection with land and real estate. Depreciation Policy and Stockholders A final consideration concerns the relation of the depreciation policy to the stockholder. As stated above, a too liberal depreciation policy results in the creation of secret reserves which may be used to the prejudice of the stockholder by an unscrupulous managing clique desirous of buying minority holdings at a depreciated value or of manipulating the stock for speculative purposes. An insufficient depreciation allowance results in a false optimism, a payment of dividends out of capital, and perhaps finally in a wrecking of the property. Except for the transient, speculative shareholder, a fixed depreciation policy based on a conservatively accurate allowance is always for the best interest of the property and its owners.