CHAPTER XXI

DEPRECIATION

WITH the modern development of business and industry and the enormous additions to the value of property, plant, appliances, and stock in trade, the question of depreciation or allowance for loss of value has naturally gained much in importance.

Indeed, the settlement of the question of what shall be allowed for depreciation is one of the most important which accountants are called upon to discuss. The auditor must always consider the adequacy or inadequacy of the provision made, before he can determine the form of the certificate or report which he can give.

It is important at the outset to distinguish between fluctuation and depreciation. The former may be a change for the better or the worse in the value of the assets and is attributable to causes apart from the business itself. Entirely extraneous influences may cause fluctuation in the value of assets and, therefore, it is generally admitted that as the actual manufacturing profits are not affected thereby one way or the other, these fluctuations in value need not be considered in the current accounts.

Depreciation, however, is a decline in the value of property such as may reasonably be expected to occur as a result of wear and tear and gradual obsolescence. It is due to the possession and use of the assets, and therefore is a part of the cost of operation. A concise definition of depreciation which has been widely used is that it is the deterioration of anything by time or use. P. D. Leake's definition, "expired outlay upon productive plant," is a good one, as is also "accrued renewals."

Before leaving the subject of fluctuation it may be well to consider for a moment what treatment may be accorded to a favorable fluctuation in the value of fixed assets and current assets. In the former case it is generally conceded that the increase may be treated as a secret reserve. In the latter case it is temporarily a secret reserve which will be included in trading

profits when the assets affected are realized. An unfavorable fluctuation, if apparently of a temporary character, may be disregarded, but when it is probable that the unfavorable conditions will remain until the time of realization of the assets affected, provision should be made for the loss; in other words, an unfavorable fluctuation should be charged against the period in which it occurred (as an extraordinary item) instead of against the period of realization.

In general it is not necessary from a legal standpoint to charge an unfavorable fluctuation in fixed assets against revenue before the declaration of dividends from current profits. While these fluctuations may be disregarded in accounts, it may be desirable, however, to present the true state of affairs to stockholders by means of a note attached to the balance sheet or included in the auditor's report.

The New York Court of Appeals, in one of its decisions, stated the theory of a depreciation reserve in a most lucid manner, as follows:

Judicial notice may be taken of the fact that in the conduct of many industrial enterprises there is a constant deterioration of the plant which is not made good by ordinary repairs and which, of course, operates continually to lessen the value of the tangible property which it affects. The amount of this depreciation differs in different enterprises, but the annual rate is usually capable of estimate and proof by skilled witnesses. No corporation would be regarded as well conducted which did not make some provision for the necessity of ultimately replacing the property thus suffering deterioration; and we cannot see why an allowance for this purpose should not be made out of the gross earnings in order to ascertain the true earning capacity.

Although the charge for depreciation is recognized by the law, and provision is made therefor in the forms supplied by the Treasury Department in connection with the Federal Corporation Tax Law, there is a wide difference of opinion as to the amount of the allowance to be made from time to time. Many company officials-particularly railway officials-prefer to regard depreciation charges as flexible. They adjust them to meet the conditions of different years, so that in time of large profits the allowance shall be large, and during bad years the allowance small, or none.

This, however, is entirely opposed to sound accounting principles, and the Treasury Department in this instance agrees with

the opinion of the accounting profession. It is important that there should be some fixity in regard to the rate of depreciation to be allowed. Under the system of varying charges for depreciation it would be impossible to fix an intelligent basis of rates, and comparisons with other years would be practically worthless. If the business man, whether in the railroad world or elsewhere, is to pass over one year without making any allowance for depreciation, it will result in a misrepresentation of conditions at the end of that year, and it is unjust and incorrect in every way to expect a good year to bear the burden of depreciation which has occurred in one or more bad years.

Causes for Depreciation: The various elements of depreciation have been very clearly described by Professor M. E. Cooley:

(1) Depreciation Due to Wear and Tear and Exposure to the Elements. This is continuous. All elements have a wearing life varying with the element itself. No element can be completely worn out; it can be worn only to a point below which it becomes unsafe or no longer serves its original function. In practice the average condition of all elements must be maintained at a high percentage of the original cost if the property is to serve its purpose properly. This percentage varies from seventy-five per cent to eighty-five per cent of the cost new of the property. The difference between this percentage of from seventy-five to eighty-five and the original one hundred is a depreciation which is inherent in the property and cannot be dispensed with. It must be met by a sinking fund, or its equivalent, otherwise this part of the original investment becomes lost.

(2) Depreciation Due to Accidents; a Sudden Depreciation. An engine or a boiler may be wrecked, and with it, other machinery. This might, and probably would, involve a considerable expense for repairs or replacement besides possibly crippling the plant in part. Cars may collide or a car may drop through a bridge. A bridge itself may fall or be carried away by floods. A storm, as a cyclone, may work havoc, entailing costs in excess of those proper to be charged to ordinary maintenance of property.

(3) Depreciation Due to Inadequacy. Cars suitable in the past had already been superseded several times by larger and better cars. This has rendered the track, structure, and bridges inadequate, and as more power is required to propel the larger cars, the power plants have become inadequate. The public demand is largely responsible for this depreciation due to inadequacy.

(4) Depreciation Due to Obsolescence. This, while closely allied to the depreciation due to inadequacy, is different in that it embraces changes due to advance in the art. More efficient and effective machinery has appeared which must be substituted for the old to keep abreast of the times. For example, in steam-engine practice the turbine has come into general use during the past five years and the art of steam turbines is at the beginning. Generators

adapted to piston-engine practice are not adapted to steam-turbine practice and must also be changed. Boilers adapted to piston-engine practice must be replaced to carry the higher pressures required. Condensers must also be changed to secure the better vacuum required to realize the full advantage of the steam turbine. Owing to the rapid disappearance of coal beds, the price of fuel must advance, and this presumably will before many years force the adoption of the gas producer and the producer gas engine. Water powers are wisely being developed, but to utilize them requires the scrapping of large parts of the machinery in use at present.

Repairs and Maintenance: It is an accepted rule that repairs and all other expenses of maintenance should be charged against profit and loss, but the auditor should not decide on the amount required for depreciation until he has scrutinized the repairs account, as in this account he may find that charges have been made for renewals and replacements which, as far as they go, apply in lieu of a depreciation reserve.

If a machine could be built like the "one-hoss shay," this question would not arise and a depreciation reserve would work out exactly, but under modern conditions it invariably happens that a machine wears out one part at a time, and if the parts are replaceable, the life of the machine as a whole may be extended almost indefinitely. Obsolescence and inadequacy are the practical factors which operate against a fair test of the possible life of present-day plant and equipment.

Mr. Henry Floy, the eminent engineer, cites the following instance:

For example, the life of the ordinary steam engine may be taken at twenty years, but it is not uncommon to find engines still in use that are very much older than this. The writer noted, within a few months, that a vertical engine installed in England in 1856 had recently been equipped with condenser, supplied with superheated steam, and was still in use at fifty-five years of age, giving economical and satisfactory results.

Methods of Applying Depreciation in the Books: (1) The FIXED PERCENTAGE BASIS is the most popular and is the one in general use. It is applied:

(a) On a flat basis, e. g., if the life of a machine is ten years, one-tenth, or ten per cent, is charged off annually.

(b) On a reducing scale basis, i. e., a rate is ascertained which, when applied to the original cost and on the diminished

value thereof as periodically determined, will reduce the book value to scrap value at the end of its estimated life.

Method (a) is more generally followed than (b), although there is in use a method which is a cross between the two and which is not scientific. It consists in charging the rate as determined under (a), but in applying it to the reducing value instead of to the original cost. For instance, if the life of a boiler is estimated at ten years, ten per cent per annum is set aside, but on the diminishing value. If the table on page 326 were calculated on this basis, the book value would be $348.68 at the end of the tenth year, instead of $100 as under the other methods.

Nevertheless, this is a popular method and must be reckoned with. The fact of the matter is that when an executive directs a clerk to "charge off ten per cent for depreciation," he does not stop to consider whether it means off the original cost or the reduced value.

The theory of and advantage claimed for (b) is that repairs and maintenance are very light during the early years of a machine and very heavy during the later years. In both (a) and (b) it is contemplated that all maintenance costs are to be charged off in addition to the depreciation.

Roughly speaking, with (b) the aggregate of depreciation and maintenance would be the same each year, whereas under (a) the aggregate during the first years would be light and during the last years heavy.

(2) SINKING FUND METHOD: If it is proposed to set aside such a sum periodically as will equal the original cost of a machine (less scrap value) at the end of its estimated life, it is customary, after taking into consideration the average rate of interest which can be secured, to pay into a fund a fixed amount periodically. The aggregate thereof, together with the accumulated interest, will equal the amount required to renew the machine in question. This method is seldom followed.

There is good authority, however, for its use where a single, large piece of property is being operated.

This point is well expressed by Mr. Floy:

In all cases involving a consideration of the expenses of keeping a property in operation, there should invariably be included allowances to cover all ultimate depreciation and replacement. For a small company or where