Chapter Ten DEPRECIATION Depreciation Defined. Depreciation is the shrinkage in value of an asset due to deterioration through wear and tear caused by use or by a mere lapse of time, accidents, inadequacy, or obsolescence. The importance of its being considered from an accounting standpoint can hardly be overestimated. Without a doubt, failure to provide for the depreciation of the fixed assets, has contributed to the failure of many concerns in the past. In a decision by the New York Court of Appeals, the following statement appears: "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." A few years ago an underwriting syndicate undertook the reorganizing of the Rock Island Companies. Its plans were to issue 7 per cent preferred stock on the basis of an 8 per cent income. To the dismay of the members of the syndicate, the Interstate Commerce Commission ruled that all the railroads under its control must include, as a charge against their profits, a satisfactory percentage of the railroad equipment, such percentage being the estimated amount of depreciation of the property. As a result of this ruling the net income of the Rock Island Companies fell to 32 per cent. This rate of income was insufficient to warrant the issue of 7 per cent stock and the syndicate collapsed. The practice of most of the railroad companies had been to disregard the theory of depreciation. They simply discarded old equipment made worthless through wear and tear and borrowed money to buy new equipment. It dosen't require much wisdom to see the folly of such a plan and the ultimate results are quite clear. A firm that divides all its net income without providing for depreciation on its fixed assets is simply "robbing Peter to pay Paul" and it reminds one of the story of the two men, shipwrecked on a deserted island, who during the time they were stranded became rich trading knives with each other. Causes of Depreciation. There are four principal causes of depreciation. These have been so ably and clearly described by Professor M. E. Cooley that we will quote him in detail: "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 75 per cent to 85 per cent of the cost of the property. The difference between this percentage of from 75 to 85 and the original 100 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 is lost. "2. Depreciation Due to Accidents; 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 replacements 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 flood. A storm or 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 superceded 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 steamengine 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 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." In regulating depreciation in respect to income taxes, deduction is allowed only for loss due to wear and tear of property used in the trade or business. This does not include provision for obsolescence since it is provided that when an asset is actually determined to be obsolete the loss may be deducted at that time. However, obsolescence should usually be provided for periodically as well as depreciation from wear and tear, as the government's permission to make eventual deduction for loss from obsolescence does not justify a waiver of the fundamental accounting rule to provide for all possible losses. Factors Bearing on Amount of Depreciation. In determining the probable amount of depreciation on any fixed asset there are certain factors to be taken into consideration such as original or prime cost, probable life of the asset, repairs and replacements, residual or scrap value and the possibility of obsolescence. 1. The original or prime cost is the basis of all calculations. It should include all the elements of cost such as freight and cartage inward, cost of installation, etc. 2. The probable life of the asset, or the number of years it is estimated to be of use, is the next factor to be considered. This varies so extensively, even with the same kinds of machines, or other assets, that it is always a difficult item to arrive at with any degree of accuracy. About the only way of determining the life of an asset is by experience. Earl A. Saliers, author of "Principles of Depreciation", says: "But efficiency, the test of present usefulness, is not the only factor that determines value. Value depends upon_the length of time over which such usefulness will continue. Two similar machines may be equally efficient today; but one may continue to be useful for two years and the other for four. Can we say that they have equal value? There may be some uncertainty in individual cases; but the uncertainty is limited within certain bounds, and to a great degree vanishes when averages are considered, just as the uncertainties of lifetime vanish when large numbers of lives are considered. The lifetime of a single freight car is very uncertain but the average lifetime of a thousand cars is ascertainable to the fraction of a year." 3. Repairs and replacements of property affect the rate of depreciation, consequently, the auditor should not decide on the amount required for depreciation until he has scrutinized the Repairs and Maintenance account. He may find items charged to this account that should have been charged to the Reserve for Depreciation account because they represent expenditures that decrease the deterioration and should have the effect of reducing the depreciation charge. The usual procedure in practice is to charge all items representing repairs and replacements to either expense or to the Reserve for Depreciation account. In deciding which account should be charged it is necessary to determine whether the expenditure is one provided for through cumulative depreciation allowances. Ordinarily small incidental items of repair, replacement and maintenance are charged to expense and larger items of renewal and replacement are charged to the depreciation reserve. Remember, that with either plan it is a deduction from income, but the point in question is, that the expenditure must not be charged to expense, and at the same time, another charge be made on account of depreciation. (See page 154 for Income Tax Procedure). Like nearly all rules, there is an exception here in connection with old, run-down or partially worn-out assets purchased with the intention of remodeling, rebuilding or rehabilitating them so they can be operated efficiently again. In such cases, it is permissible to charge all repairs and renewals to the asset accounts affected, thereby capitalizing such expenditures. 4. The total amount of depreciation of an asset will be the difference between its original cost and its residual or scrap value when it ceases to be useful and must be discarded. Whatever can be realized from the sale of an asset at the time it is discarded reduces the loss and thereby the amount of depreciation. 5. Some assets are quite likely to become obsolete even before they have become useless through wear and tear. The possibility of obsolescence, therefore, is a matter for consideration. Methods Used for Calculating the Depreciation. There are several methods advocated for calculating the proper amount or rather the annual rate of depreciation. We shall discuss briefly the principal methods used. 1. Straight Line Method. In this method the life of the asset is estimated and the cost of such asset less its scrap or residual value is written off over such estimated life. The amount of depreciation for each year is found by dividing the difference between the cost and residual value by the number of years of the estimated life of the asset. To illustrate, let us assume that the cost of a certain machine is $81.00, its estimated life is four years, and its residual or scrap value is $16.00. By deducting the scrap value, $16.00, from the cost, $81.00, we get $65.00, the amount the machine is expected to depreciate in four years, its estimated life. $65.00 divided by the number of years, four, shows $16.25, the annual amount of depreciation to be charged off. The amount of annual depreciation, $16.25 divided by the cost, $81.00, shows the rate of depreciation to be 20 5/81%. This is the simplest method for calculating depreciation and consequently is very popular. It is the method in general use, and is acceptable to the Interstate Commerce Commission and the Internal Revenue Department. The method has been criticized by some accountants and others for various reasons. Saliers says in this connection: "It is free from interest complications, and its employment does not require a knowledge of the logarithmic or any other method of finding roots and powers of numbers. Speaking generally, there appears to be no reason why the straight line method does not approximate actual depreciation as nearly as any of the complicated curves at times advocated, apparently on the assumption that actual depreciation finds a counterpart in the accuracy of their mathematical computations." 2. Diminishing Value Method. In this method it is customary to estimate a minimum life of the asset and then depreciate the residual value each year. That is, instead of basing the annual depreciation during the life of the asset on the original cost, as in the straight line method, it is based on the value of the asset at the beginning of that period after having deducted the total amount of previous depreciation. A percentage rate is ascertained which, when applied each year to the balance remaining after the similar deduction for the preceding year, will reduce the balance to the scrap value at the end of life of the asset. Using the same problem as shown under the straight line method, it will be seen that it requires a rate of 33% to reduce the asset to a scrap value of $16.00 in four years. Note the following calculations: Original cost of machine.... .$81.00 27.00 54.00 18.00 36.00 12.00 24.00 8.00 $16.00 It It will be seen that the amount of depreciation is greater at the beginning but decreases with the life of the asset. is held by some that this is reasonable because the cost of repairs and maintenance is least while the asset is new but increases as the asset is used. Therefore, the total depreciation and upkeep will be nearly uniform each year. On the other hand, the concern is forced to charge off a larger amount of depreciation at the beginning of its existence when profits may be small. Another objection is the fact that it involves a complicated mathematical calculation, and the annual rate of depreciation gives little indication to the ordinary man of the period required to write off the asset. 3. Annuity Method. In this method the plan is to estimate an amount which, if annually set aside at interest, would at the end of the life of the asset amount to the difference between cost and scrap values. A sum is determined which, when set |