under the above caption is that caused in a plant by the exhaustion of the mines or timber lands in connection with which the plant was constructed. Most of the value of coke ovens, for instance, is gone when the mines for which they were constructed are worked out. Consequently, in determining the amount to be written off for depreciation of mining and lumbering plants, the factor of the probable future output of the mines or lands will be an important one and it will frequently be found advisable to base the plant depreciation charge on the output. Certainly this should be done where it is evident that the plant will outlive the exhaustion of the mines or lands. In such cases the depreciation charges should be sufficient to absorb the entire cost of the plant, less residual value, by the time the mines or lands are exhausted, even though at that time the plant might still be in good operating condition.

Sinking Fund Requirements to Retire Bonds, etc., Must Not be Confused with Depreciation Allowances: The trained accountant or engineer recognizes the distinction between depreciation and sinking funds and never confuses the two terms. Not so, however, with lawyers and business men. The modern industrial bond is not popular unless a provision is inserted in the trust deed requiring that a sufficient sum be set aside annually, or otherwise, to retire the bonds before or at maturity.

It is usual to provide that the installments must be provided out of earnings, and this is a wise course to follow, as it serves to keep down dividend declarations during the life of the bonds. Nevertheless, the sinking fund installments are capital expenditure and do not properly appear among operating expenses, but should be stated as deductions from the net profits when ascertained. This course fulfills the obligation imposed in the trust deed and yet does not permit the surplus to be overstated.

Now the sinking fund provision may be greater or less than the amount required for depreciation, aside from the fact that one is an operating expense and the other is a discharge of a capital obligation. Therefore, depreciation should be calculated and charged against earnings before the net profit is determined irrespective of the existence or nonexistence of sinking fund requirements.

The common misconception of the proper treatment of com

pulsory sinking funds can be explained by an illustration taken from actual practice. A manufacturing corporation handling a patented device issued bonds aggregating $375,000, payable in installments of $25,000 annually for fifteen years. Having in mind possible competition and obsolescence of its property, it was provided that the sinking fund installments be charged against earnings. The president of the company had a contract under which he was to receive a bonus of five per cent of the net profits in addition to his salary, but it was specifically provided that as to him the charges against earnings should not include the sinking fund installments. In making up the first year's accounts the auditors decided that the depreciation reserve, as nearly as could be determined, should be stated as $25,000, and this amount was included among the operating expenses.

When their report was submitted to the directors, the president referred to his contract and stated that the sinking fund provision and depreciation were synonymous and that he was entitled to five per cent of the earnings before any deduction was made for depreciation. The majority of the directors agreed with him, with the result that the company has overpaid the president $1,250 per annum for several years.

Perhaps the time will arrive when depreciation will be generally considered as a prime operating cost. If it is so treated throughout the accounts, no such misunderstanding as that above cited could occur.

Depreciation Is an Operating Expense: We often see a statement in published reports that a corporation has realized net profits amounting to a certain sum, and that out of these profits an allowance for depreciation has been made. It would be just as logical to state that a candy manufacturer had earned a net profit of one hundred thousand dollars and that out of said one hundred thousand dollars there had been set aside twenty thousand dollars 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. Net profit means only one thing in the vocabulary of the

professional auditor, and that is the excess of income over operating costs, expenses, and losses. It cannot be determined by taking into account all of the income and a part only of the charges against income. If the provision for depreciation is not such an item as can be included among the costs of operation, then it is a misnomer.

This view of depreciation is well expressed by Professor Henry C. Adams, writing with respect to railroad accounts, but the principle enunciated applies with equal force to industrial

accounts.

When carried to its final analysis the question of formal depreciation charges to operating expenses is simply a question of what constitutes cost of operation, and the time when such cost shall be acknowledged in the accounts. The position which the Interstate Commerce Commission's system of accounts assumes on this point is, that the depletion of an asset which represents an investment through the use of that asset in operation creates an item of cost of operation which should be reflected in the accounts when the fact of such depletion takes place, and that a statement of net revenue made without including this element of cost in operation expenses is an

erroneous statement.

Depreciation a Local Issue: The auditor must use his own judgment in passing on rates of depreciation just as much as he does when he inspects purchase vouchers. In one locality steam coal may be two dollars a ton, in another four dollars. The variation may be entirely legitimate. In one locality boilers may depreciate 71⁄2 per cent annually, in another the rate may be 15 per

cent.

It is not merely a question of the life of the boilers, because no experienced engineer or boiler manufacturer would answer the question unless he knew the use to which the boiler would be subjected, the climate, the water, the class of labor, the probabilities of shut-downs, etc. And similarly with almost all other classes of property which depreciate by wear and tear. Therefore, wherever rates of depreciation are mentioned in this chapter, they must be taken as suggestive only and in a relative sense. The student without other experience can thus broadly acquaint himself with general observations and modify his views later on as he gains experience.

Investment of Depreciation Reserves: It has been urged that unless an amount corresponding to the reserve for depreciation

is invested in marketable securities, it is not a de facto reserve, but merely a book account. This is a matter of secondary importance. The principal point to consider is whether or not there has been charged to income a sufficient sum to cover the loss by wear and tear and obsolescence. So long as this is done there is no possibility of the amount thereof being paid out in dividends. It is left in the business in the form of cash or any other undivided asset. The question of its investment is immaterial.

The concern that can and does purchase securities equal to its depreciation reserve and retain such securities until the proceeds are needed for the purchase of machinery, etc., could certainly be depended upon to renew its machinery when necessary even though its depreciation reserve was represented among its current or fixed assets.

The life of plant and equipment is too uncertain to warrant the purchase of bonds which are to be sold to finance renewals. A well-managed plant is attended to daily as to its up-keep, and renewals and changes are made as needed.

Importance of Provision for Obsolescence: It has been pointed out that actual depreciation is ascertainable. That is to say, machinery, for instance, cannot be operated efficiently if it falls below, say, 70 per cent of its condition when new. If its theoretical life is ten years and 30 per cent has been set aside during the first three years, the question then arises as to what to do at the end of the fourth year. If the shop is properly managed, it is probable that the machine is worth 70 per cent of its cost and will remain so until superseded. But no manufacturer can depend on keeping up his equipment by renewing old machines in whole or in part. It is inevitable that improvements will come so long as the times produce inventors and men of initiative. Therefore the manufacturer who is willing that the product of a machine shall bear the cost of the machine continues to charge operating and credit reserve for depreciation with such an amount as will enable him to discard his old machine as soon as a better one appears.

One of the foremost efficiency engineers in this country told the author that the tendency to scrap old machines and buy new ones had often been carried to an extreme; that in some cases a new machine of twice the capacity of an old one costs much more

than twice as much, and that the interest, depreciation, and other charges against the new machine more than offset the saving in time or increase in production.

Nevertheless, the 'tendency to discard is strong, and the auditor who endeavors to charge out the cost of a machine against its product must set up a reserve for obsolescence or he will find the reserve for depreciation insufficient.

It is not advisable to separate the accounts in the books nor on financial statements. No manufacturer cares to publish his estimate of that part of his equipment which is getting out of date.

Depreciation of Different Classes of Property: Passing from a general discussion of the rules which have the approval of competent authorities, it is desirable to study their application to various classes of assets. For the sake of convenience we will take up the depreciation of fixed assets as they appear in Chapter IX (page 117).

Land: It is usual to dismiss this item with the statement that land does not depreciate. Nothing could be further from the fact. The great bulk of land in the United States is depreciating through use just as much as depreciation occurs in machinery through use.

The land on which buildings are erected or which is used for storage purposes, etc., may not depreciate, and the aggregate of such holdings is very large, but the auditor must inquire into the purpose for which land is used, its location, etc., before he can decide offhand that the land has not depreciated.

Land used for agricultural purposes may depreciate through use and does depreciate unless a certain rotation of crops is followed or unless fertilizers are used. The latter is equivalent to the cost of maintenance and repairs in a factory.

The price of flax seed has increased enormously because during the early years of farming in the West the vitality of the land was exhausted by raising a crop which impoverished the soil to such an extent that the farmers were obliged to discontinue the raising of flax. During the period when this crop was using up the value of the land the farmers should have set up a reserve for depreciation, and it would have been apparent that the net price realized from the flax crop was not nearly so high as it seemed,