aside each year at compound interest, will accumulate, during the life of the asset, and will just equal the scrap value at the end of its estimated life. Hatfield, in his Modern Accounting, says: "It rests upon the assumption that the cost of production includes not only repairs and the depreciation of machinery, but as well, interest on the amount of capital invested in the asset. Depreciation on this theory should be a sum figured as a constant annual charge sufficient not only to write off the decline in value, but also to write off annual interest charges on its diminishing value." Using the same problem as above, it will be seen that the annual amount of depreciation is equivalent to a rate of 27 47/162% based on the original cost. Note the following calculations: ........ 22.10 34.65 3.46 38.11 22.II .$16.00 Depreciation third year (27 47/162%) . . . . (Interest at the rate of 10 per cent was used for convenience in arithmetical calculations.) This method is objectionable because of the inclusion of interest on invested capital. Of course, the writing up of the asset is offset by the increased depreciation. The method is inconsistent unless interest is charged on all the capital invested. 4. Production Unit Method. In this method the estimated life of an asset is based on its production. The plan is to charge off an established rate per unit of output. It may be applied to such assets as diminish in value in exact ratio to the amount used. For instance, if the machine mentioned above was designed to produce 1,000,000 units at a total cost of $1,000.00, the depreciation charge would be 1 mill per unit of production. Comparison of Methods for Calculating Depreciation. Walton says with regard to the significance of each method: "(a) The Straight Line Method distributes the burden of depreciation equally over all the years, without regard to the constantly increasing repairs. "(b) The Diminishing Value Method starts with a heavier burden of depreciation which gradually diminishes, the theory being that as the repairs increase on account of the increasing deterioration of the asset, the decreased depreciation tends to equalize the burden over the years. It also provides for a residual or scrap value, as the carrying value never reaches zero. "(c) The Annuity Method takes into consideration not only the cost of the asset, but also the interest on the diminishing value. As the credit to interest diminishes each year and the charge for depreciation remains constant, the net expense increases annually. In addition, few accountants are in favor of considering interest on the cost of fixed assets as an operating expense." Dicksee, a prominent authority, favors the first method for short-lived assets, the second for machinery in general, and the third for long-time terminable leaseholds and similar assets. Where courts have prescribed depreciation, they have generally allowed the basis of calculation to be left to the discretion of the company. This is also true with the Internal Revenue Department. The Interstate Commerce Commission prescribes the first method for figuring depreciation. It is compulsory with concerns coming under the Commission's Control. Accounting Procedure with Regard to Depreciation. Either a reserve for depreciation or a reserve fund may be created, or the asset account may be credited direct for the amount of the depreciation. (a) Writing Down the Asset. If the amount is credited direct to the asset account, it is known as writing down the asset. The principal objection to this plan is that the original cost of the asset is lost sight of. From an accounting standpoint, the asset accounts should show costs of assets on hand at the date of the Balance Sheet. If the depreciation is credited direct to the accounts with assets, this policy is interfered with making it necessary to analyze the accounts in order to ascertain the cost of assets. (b) General Reserve for Depreciation. Some firms create a general reserve for depreciation. This is considered poor accounting for the reason that the account includes the depreciation on all classes of assets and it is impossible to ascertain the net carrying value of any particular asset or class of assets without first analyzing the account. It is also difficult, if not impossible, to verify its accuracy as time shows how much the actual depreciation on a special class of assets has been. It will be seen, therefore, that the same objections may be made to either of these plans. (c) Specific Reserve for Depreciation. Without a doubt this is the best plan of all. The amount of depreciation is credited to a reserve for depreciation on each asset affected. This reserve is then deducted from the asset to which it applies in the Balance Sheet so that the asset is shown at its cost, less depreciation, and its present value shown as a current or fixed asset. This is the net carrying value to the business. (d) Reserve Funds. In all the above methods the effect of the provision for depreciation is simply to provide for depreciation and deterioration by setting aside a part of the profits annually and preventing their distribution. However, creating the reserve does not set apart a specific sum and label it for the purpose of replacing certain assets. Creating a reserve fund is entirely different from creating a reserve for depreciation. The object of the reserve fund is to set aside annually a certain sum estimated to be sufficient to replace a certain asset when it has become worthless or obsolete. In the first three methods outlined above, the problem of interest does not arise. When a reserve fund is created and a certain sum set aside and invested in securities, these securities will earn interest which in itself may increase the fund or may be treated as an income on the books and not a part of the fund. While this plan has its advantages, at the same time it reduces the working capital of the company by tying up a certain part of its funds in such a manner that they cannot be used for any other purpose than that for which they were intended. By the reserve for depreciation methods, that part of the profits set aside, are retained in the business as working capital and may be reinvested in stock-in-trade or other assets, the income from which will very likely be greater than could be realized from a reserve fund invested in conservative securities. In order to illustrate the four methods explained above, let us assume that the depreciation on a certain machine costing $1000.00 amounted to 10 per cent the first year, or $100.00. Under the first plan a journal entry would be made as follows: Manufacturing Expense...... Machinery. $100.00 $100.00 Note that the Machinery account is credited for the amount of the depreciation thus reducing its value on the books. Under the second plan the following entry would be made: Manufacturing Expense.... Reserve for Depreciation... $100.00 $100.00 A general Reserve for Depreciation account is here credited. The same account would also be credited for the amount of depreciation on buildings, furniture, delivery equipment and possibly even for a reserve for doubtful accounts. The asset account with Machinery is not affected by the entry. Under the third plan the following entry would be made: ..$100.00 Reserve for Depr. on Machinery. $100.00 A special Reserve for Depreciation on Machinery account is credited. The asset account with machinery is not affected. In stating the value of machinery in the Balance Sheet, the reserve for depreciation on machinery is deducted and only the net amount listed as an asset. Under the last plan two entries are necessary, the first setting up the depreciation and the second establishing the reserve fund. It will be seen that the first entry is the same as that under the third plan above. The second entry is entirely different and is really no part of the depreciation entry. After this last entry has been made the cash would be turned over to a trustee, much the same as in the case of a sinking fund, and he would be instructed as to the handling of the fund. It is usually invested in high-grade securities. Appreciation. It is always unwise to write up the value of assets even when they have undoubtedly increased in value. If we are to stick to the rule that no profit can be made except through sales, then we can never, under any circumstances, show appreciation of assets by increasing their book value. Sometimes it is held that the appreciation offsets the depreciation and that no provision for depreciation need be made. For instance, the increase in the market value of agricultural land, might be such that it would seem that no depreciation should be considered. The fact is that the present increase in market value is a mere fluctuation in prices and may suddenly decrease while the productive value would not in the least be affected by such fluctuation. Experience has shown clearly that agricultural land is depreciating in productive value through its use. At present the upkeep is not such as to maintain the original productive value of such land and therefore, it is advisable to provide for certain depreciation. Under no circumstances should an estimated appreciation of one asset be considered to have offset the depreciation of the same or another asset. INCOME TAX PROCEDURE Depreciation is a Proper Deduction from Income. It has been shown that depreciation is an operating expense and that it should be charged off by writing down the value of the fixed assets or by setting up a reserve for depreciation, preferably the latter. The Income Tax Law has clearly recognized this theory. Income Tax Law. Section 214 (a-8) [Individuals]; Section 234 (a-7) [Corporations]. "In computing net income there shall be allowed as deductions: "A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business." Expenditures Capital Expenditures not Deductible. which actually increase the value of the assets cannot be deducted as an expense. Income Tax Law. Section 215 for individuals and Section 235 for corporations. "That in computing net income no deduction shall in any case be allowed in respect of— "Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." Replacements and Renewals must not be Deducted Twice. As previously explained expenditures for repairs and replacements cannot be deducted as an expense and again be provided for through a depreciation reserve. Income Tax Law. Section 214. (c) "That in computing net income no deduction shall in any case be allowed in respect of "Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made." (Reg. No. 33, 1918, 432.) "The cost of incidental repairs which neither add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as expense, provided that the plant or property account is not increased by the amount of such expenditures. Such repairs, to the extent that they arrest deterioration, should have the effect to reduce the depreciation charge otherwise deductible." Income Tax Primer, 1918, question 99. Ruling. "If a tax payer wishes to claim the full amount of depreciation estimated to have occurred in the value of a building or other property used for business or trade purposes, he may do so, but this precludes his claiming a deduction to cover any amount expended during the same year in making repairs. If he wishes to claim a deduction on account of repairs, their cost must be deducted from the full amount of depreciation, and the balance |