Fundamental Purpose of Depreciation

Under the head of accounting for depreciation, which forms the subject of this and following chapters, will be considered:

Though much has been written about the causes and kinds of depreciation, the necessity of considering it, and methods of calculating its amount, so far as the author knows there has been no adequate presentation of the fundamental purpose of the depreciation charge viewed both from the valuation or balance sheet point of view and the operation or profit and loss standpoint. The statement is frequently made that the purpose of depreciation and the necessity for considering it is to maintain intact the value of the original capital invested. In so far, therefore, as this necessitates a periodic charge against revenue, resulting in a retention in the business, either in a specific or floating form, of some of the revenue-producing assets, the operating or profit and loss phase of the business is affected. This secures the integrity of the original fund of capital by making the revenue receipts unavailable for distribution among the stockholders until the portion of the assets wasted away has been made good. This view of depreciation has as its actuating purpose a showing of correct values in the balance sheet, with little regard to the purposes to be served by the depreciation charge against operations. This emphasis of the problem of valuation is usually looked upon as primarily the engineering viewpoint.

Depreciation a Cost of Operation

On the other hand, many students of the problem view the depreciation charge as incurred for the sole purpose of determining the correct costs of doing business. Unquestionably, depreciation is a cost of production. A portion of the service life of equipment goes into each unit of the product, and depreciation constitutes a cost which must be borne by the product with as much reason as the labor power that fashions and forms it and the raw material out of which it is made. To determine a cost of production and a profit without the inclusion of the depreciation charge would be, as R. H. Montgomery[26] says, just as logical as “to state that a candy manufacturer had earned a net profit of $100,000 and that out of said $100,000 there had been set aside $20,000 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.... If the provision for depreciation is an item which cannot be included among the costs of operation, there is something wrong.”

This view of depreciation attempts to show the correct costs in the profit and loss statement of operations, without much regard to its effect on the balance sheet except that, in so far as every charge against operations is reflected among the assets, the fact of its inclusion as an operating cost automatically works also as a means of declaring correct values. Under this view—which may, without any misstatement perhaps, be called the accountant’s viewpoint—the emphasis is placed on the effort to show true costs of the product, and only incidentally a true valuation of the assets.

Complication of Short Fiscal Periods

Theoretically there is no conflict of views here—only a difference in emphasis. It is purposed, however, to show some of the practical difficulties encountered in the full application of either view. As has been stated in an earlier chapter, the ideal time in so far as depreciation is involved for the determination of financial results would be the time when all the elements of production entering into the product have been completely used up—if this were possible. There would then be no troublesome problems as to inventories, accruals, or deferred charges. The fiscal period would coincide with the natural service-life periods of all the producing elements. The problem of depreciation would then be a simple one, and the entire value of the equipment would be a charge to the product turned out during its life-period. Such a method of determining the financial results of an enterprise is, of course, merely fanciful. There is always, and will be always, an overlapping of the life-periods of the various units of a plant. Furthermore the practical necessities of modern business and competition require a much shorter fiscal period with a more frequent figuring of results and showing of condition. It is due to this shortening of the fiscal period to one month, six months, or a year that the difficulties of the depreciation problem arise and inaccuracies of statement are consciously or unconsciously made.

The handling of the problem hinges on the answer to the question as to the correct basis for the distribution of the depreciation charge. Shall a fiscal period of arbitrary length be used as the basis for determination of the service life of the operating equipment? Or shall the life of inanimate equipment be measured in terms of units produced, service rendered, results achieved, just as human life and age may be measured in terms of intensity of thought and action? It is unfortunately true that once the depreciation charge is settled, this same charge is constantly applied with little adjustment to changing conditions. Thus, varying intensity of service is not reflected in the periodic charge.

The Factor of Idle Time

Were it possible to foretell length of service life in terms of units of product instead of units of time, a much better approximation to actual results would be secured. And this very thing is attempted under almost all methods of estimating depreciation. The life-period of the equipment is estimated on an assumption of average, normal use of the equipment—an assumption which will give good practical results when and so long as operations are normal or average. When, however, a period of depression comes and much of the equipment is idle, it is clear that that period would be burdened unduly with a depreciation charge based on years or months of service life. On the other hand, a period of feverish activity would not bear its just share of the burden of wasting assets. The period which is really overburdened must necessarily reflect it as an undervaluation of the assets—more has been charged off than has been used up; while the opposite is true of an underburdened period. Of course, on the theory of averages, by the end of the life-period of an asset all inequalities would be ironed out. Some methods of cost-keeping take this factor of intensity into account and spread the depreciation charge on a man-hour or machine-hour basis, which proportions it somewhat equitably to the product turned out by the use made of the machine and not to its elapsed life in days or months. The best that can be hoped for is as near an approximation to the truth as possible.

Depreciation a Means of Financing

Another view of the purpose of the depreciation charge is that it is a method or means of financing depreciation as it is sometimes termed. Under this view the effect of the depreciation charge on intermediate periods is lost sight of and it is used solely as a means of securing a sufficient contribution in hand at the end of the service life of the asset to finance its replacement. In other words, no attempt is made through the periodic depreciation charge to secure an accurate or necessarily true statement of the values of the assets, nor to see that the product of a given period is burdened with its just share of all costs, though this may be an incidental purpose. H. V. Hayes[27] in discussing this phase of depreciation says:

“It is argued that the plant unit ‘deteriorates’ year by year and that this ‘deterioration’ is the true measure of the ‘depreciation’ in the value of the unit during the intermediate years of its life, and, being a physical condition of the plant, can in no way be measured by the purely financial considerations upon which the reserves for depreciation necessarily must be based. Such a line of reasoning is absolutely faulty. Any attempt to reconcile ‘deterioration’ with ‘depreciation’ at any intermediate period in the life of the plant of an undertaking, is not only unnecessary but futile. The error in such an attempt arises from a failure ... to recognize the fact that ... if definite agreement has been reached as to the serviceable life (of the asset), the physical ‘deterioration’ of the unit, at any time during its life, can be a matter affecting its intrinsic value in no way whatever.”

Danger of the Financing Viewpoint

The above statement is a fair presentation of the case for depreciation as a financing device. It would seem, however, that the exponents of this view lose sight of the inevitable fact that the depreciation charge is pro tanto an evaluator of the wasting asset during the intermediate period of its life. Therefore a logical conclusion to be drawn from the view as expressed in the quotation above, would be the countenancing of any method by means of which provision could be made to replace the asset by the end of its life, no matter whether the charge was spread evenly over its life, was made all in one year, or was made to depend on the amount of the net profits at the end of a given year. This latter alternative is a dangerous policy, always to be deprecated, for depreciation is a cost of production to be taken account of before profits can be determined.

After all, it may be said without fear of serious contradiction that all three views, i.e., the engineering, the accounting, and the financing viewpoints, must be held in mind in any adequate treatment of the depreciation charge. The important point from the commercial and accounting standpoint is to secure a fair and equitable charge to each unit of product, regardless of whether or not the burdens of each fiscal period are equal. This is particularly evident when wear and tear from use is the effective factor in depreciation—and it is also contended that the factors of obsolescence and inadequacy may be as successfully and relevantly estimated in terms of business output as in years. If this results in an accurate valuation of the asset—and it is conceded that from the engineering viewpoint it may sometimes so result—the inaccuracy is of minor importance. According to the general law for the valuation of fixed assets, changes in the market need not and should not, as a general thing, affect the values at which the assets are carried on the books of a going concern. It is, of course, a corollary to the main proposition that this treatment also makes adequate provision for financing the fact of depreciation. Various methods and means for the accomplishment of these purposes are given in Chapter IX.

The Standardization of Depreciation Rates

The determination of the rate of depreciation of a given asset is essentially an engineering problem. But as the accounting for depreciation is dependent on the rate, and the records of the accounting department must furnish much of the information for estimating the rate, the whole problem of fixing depreciation rates will be considered under the one head. Much study and effort to reduce all the conditions under which assets depreciate to a common basis and so to a definitely stated rate for each set of conditions, have, so far, come to naught and all qualified experts say without reserve that the rate of depreciation is an individual problem. It is to be hoped that a further gathering of statistics as to expectations of life of different assets under varying conditions will ultimately furnish tabulations, corresponding to insurance tables, according to which under known and expected conditions a fairly accurate rate of depreciation for a particular asset may be made. Unlike insurance rates, however, the depreciation rate once established will not necessarily remain constant, but must be subject to a periodic revision in the light of new data and conditions.

Effect of Local Conditions

Many factors enter into the rate of depreciation. They may be classed roughly as “stable or normal” factors and “contingent” factors. It should be constantly borne in mind that in the present state of the actuarial development of the subject, general rates, i.e., rates which will apply without readjustment, cannot be determined. For the determination of individual rates local conditions are always the controlling factor. An illustration in point is given by Henry Floy,[28] showing the varying rates used by thirty-one different concerns for the depreciation of their rolling stock equipment. The methods vary in almost every case, comprising annual charges of an arbitrary amount, per cent of the original cost, cents per car mile, arbitrary deductions from income irregularly applied, per cent of gross earnings, per cent of present estimated values. Reduced to a common basis, the per cent methods show a range of expected life varying between ten and one hundred years. While it is improbable that had the determination of the depreciation rate for the different concerns been in the hands of the same expert, there would have resulted these bewildering variations in method, still it does bring out in strong relief the fact, well recognized by experts but so often lost sight of by those unacquainted with the technical phases of the problem, that local conditions are a controlling factor; and that until local conditions can be somewhat standardized there is no hope of establishing rates of depreciation which will be of general application.

Factors in Determining Depreciation Rate

In the determination of rates the factors to be taken into account are:

These constitute the most important stable or normal factors. Among the contingent elements, the most important are:

At the time of installation the rate of depreciation must be based only on the normal factors—things which can with reasonable certainty be counted on. At intermediate periods in the life of the asset, a physical inspection should be made to compare the actual depreciation of the property with the estimated. If, then, it is found that any contingent factors have become real or reached the point of reasonable expectancy, these provide the basis for an adjustment of the rate for the remaining life-term of the asset.

Basis of Normal Rate

With regard to the normal rate, the following items demand first consideration:

• “1. Exterior or movable apparatus
• (a) Abuse
• (b) Neglect
• (c) Temperatures
• (d) Oxidation
• (e) Irregular shocks in use, such as starting
•  or braking, also road or rail defects
• 2. Installed operating and generating machinery
• (a) Reversals, increased by rapidity and aggravated by shock
• (b) Irregular loads or service, aggravated by speedand sudden character
• (c) Excessive usage, resulting in increase of temperature of parts
• 3. Fixed equipment including boilers and piping
• (a) Excessive and irregular strains
• (b) Interior causes of decay
• (c) Chemical action

—all these being of greater or less effect, according to the time of daily usage and lack of periods of rest.”[29]

Policies as to Repairs

Without doubt the most important single factor in the determination of the depreciation rate is the normal policy as to repairs and maintenance. Physical deterioration is constantly at work. If this is counteracted by a liberal maintenance policy, not only is more efficient service secured but a longer service life is thereby insured. As soon as repairs are needed, although the efficiency of the asset may not be immediately impaired, the rate of deterioration is much accelerated unless the condition is corrected. Deterioration takes place day by day, but repairs obviously cannot be made at such short intervals—both because of the difficulty of detection and also because such a policy would not be economically practical. Every concern must consider its own peculiar problems and determine from these what shall constitute its normal repairs policy, and so far as possible this should be adhered to. The charges for repairs are bound to be of a more or less irregular character. Their handling is discussed on page 147.

Regardless of what the established policy as to repairs may be, conditions are sure to arise which make strict adherence to it impossible. There may occasionally be lack of funds at the time repairs are customarily attended to; it may be impossible to get the expert labor needed or the parts to replace worn-out units; or, and of oftenest occurrence, the need of repairs may coincide with a period of intense activity when the plant is being worked to its limit and in consequence there is no opportunity for making repairs. It is clear that rates based on one shift and the normal use of equipment during eight hours would be inadequate for three shifts and twenty-four hours of use; for in addition to a threefold intensity of operation this makes impossible adherence to the normal repairs policy based on an eight-hour schedule.

Depreciation Rate an Engineering Problem

From the above discussion it is apparent that the determination of rates is essentially an engineering problem. The accountant, however, needs a knowledge of the fundamental considerations and requirements of fixing depreciation rates and an appreciation of the difficulties of the problem. As Henry Floy[30] says: “What engineer is able to foretell the misuse and neglect or care and high degree of maintenance that any given apparatus or ... property as a whole will receive, even during the next five or ten years, with vicissitudes of climate, load conditions, changes of management, and requirements of the public?” On the other hand, in the opinion of another prominent engineer, “Consideration of these matters (misuse, neglect, etc.) may eventually form the basis for a systematic appraisal of the probabilities of life, or average of the risks, which would provide a method for the insurance of the life of machinery.”

The author does not attempt to discuss the relative merits of the two contentions other than to point out the fact that engineers are not discouraged in spite of the many contingencies and uncertainties inherent in the problem. They are constantly gathering data from which conclusions as to rates are being formed, the use of which is being compelled by regulating bodies. It is possible that the problem will ultimately be worked out on some kind of an insurance basis.

Attitude of Regulatory Bodies

At the present time the attitude of most regulatory bodies—public service boards, federal commissions, and tax officials—is well expressed by a regulation of the Public Utility Commission of New Jersey which says that, “Until otherwise prescribed, the amount estimated to be necessary to cover such wear and tear and obsolescence and inadequacy as have accrued during any month shall be based on a rule to be determined by the accounting corporation; such rule may be derived from a consideration of the said corporation’s history and experience. A general statement of the rule in use by each company, together with the general information upon which it is based, is to be filed with the Board of Public Utility Commissioners.” The trend at the present time is towards a more thorough supervision of depreciation rates on the part of many public service boards, and the future will undoubtedly see interesting developments.

Methods of Handling Repairs

Three distinct practices are met with in handling repairs and renewals on the books. The most general method is dictated by ease of application and rests on the theory of averages, viz.: that the amount of repairs annually recurring for depreciating equipment in all degrees of deterioration and all stages of decay and age is a fairly constant figure which secures an equitable distribution over the product of the different years. The larger the plant and the greater the variety of the equipment used, the more nearly does this work out as expected.

Further consideration will be given to this point in the discussion in Chapter X of the effect of the various methods used for calculating depreciation on the equality of the distribution of the charge.

Another method, used in plants where a very accurate determination of the costs of production is desired, has as an outstanding feature a preliminary estimate, made at the time of installation, of the expected amount of repairs needed during the entire life of the asset. Periodically this estimate, or proportional share thereof, is brought on the books as a charge to Repairs and credit to Reserve for Repairs and so is spread evenly over the service life of the asset. As repairs are actually made, the cost of these is not charged against operation but against the reserve created for that very purpose. At a given time, the status of the reserve account shows: (1) if the equipment has just been placed in a normal state of repair, the under-or over-estimate of the amount of actual repairs needed, or (2) if the equipment is not in repair, the reserve account gives an index of the probable amount of deferred maintenance. Both items of information are of value in the proper management of properties. It is to be expected, of course, that during the early years of the life of an asset there will be a fairly large credit balance in the reserve because repair charges are light. The credit balance so accumulated will be needed during the later years when the costs of maintenance become heavier.

The third method, which is a variation of the second, has as its characteristic feature the inclusion of the repairs cost with the depreciation charge. This likewise necessitates a preliminary estimate of the amount of expected repairs during the life of the asset. Instead of being handled separately, it is added to the depreciation rate and in this way charged against the product. This method has been prescribed in the case of some utilities in England but is not much used here. Under this method two depreciation estimates of probable life are necessary, viz.: (1) maximum life brought about by an inclusion of repairs, renewals, etc., and (2) minimum life without such repairs. By this it is not meant that other methods of calculating the depreciation rates fail to take cognizance of the repairs factor, but that this method specifically calls attention to it and includes it in the charge made. It seems best for regulatory boards to make a separate book record of repairs and depreciation, thus insuring against any oversight of the factors of depreciation and also insuring the correctness of a statement of condition.