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Until the Treasury permits the deduction of bad debts reserves the returns will not reflect good accounting practice.

PRACTICE IN GREAT BRITAIN.—The English income tax law allows a deduction for bad debts “actually incurred.” The interpretation under the British act is in line with sound accounting.

Schedule D of the Income Tax (Consolidated) Act, 1918, (Great Britain), provides that:

3. In computing the amount of the profits or gains to be charged, no sum shall be deducted in respect of .... (i) any debts, except bad debts proved to be such to the satis

faction of the commissioners and doubtful debts to the extent that they are respectively estimated to be bad. In the case of the bankruptcy or insolvency of a debtor, the amount which may reasonably be expected to be received

on any such debt shall be deemed to be the value thereof: In effect the British law leaves the provision for bad debts to the honesty of the taxpayer.

SUPREME COURT DECISIONS.—The Supreme Court of the United States in construing the federal income tax law of 1864 (amended in 1867), decided that in ascertaining profits a company was “entitled to deduct from the earnings items of loss and depreciation on book accounts and other choses in action.” [Little Miami, Columbus & Xenia R. R. Co. v. U. S., 108 U. S. 277 (1883).]

The wording of the act of March 2, 1867, is as follows:

.... losses actually sustained during the year arising from fires, shipwreck, or incurred in trade and debts ascertained to be worthless, but excluding all estimated depreciations of values and losses within the year on sales of real estate ....

The word “depreciation” seems to cover fully the setting up of a reserve for bad debts, as that is precisely the object for which such a reserve is created, i.e., to reflect on the books the depreciation known to exist in the value of the accounts receivable as a whole.

Another decision of the Supreme Court is in accord with the one quoted above.

DECISION. In United States v. Frost, 9 Int. Rev. 31 (1869), it was held that promissory notes, book accounts, etc., due during the year, are the evidences of debts. Whether or not they are gains, profits or income for that year, within the meaning of the internal revenue law, depends upon their value intrinsically or their convertibility into money, property or available assets. If they have only a nominal, and not a real value or convertible quality, and a man has realized nothing from them, and, therefore, does not return them as a part of his income, because he fairly and honestly believes they are not real gains or profits, he cannot be convicted of an untrue return.

CHAPTER XXIX

DEDUCTIONS FOR DEPRECIATION

Depreciation 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 assets, and therefore is a part of the cost of operation. P. D. Leake defines it as "expired outlay upon productive plant.” The phrase "accrued renewals” sometimes used to describe depreciation is illuminating. It is to be noted that depreciation is usually treated as a comprehensive term to include all declines of the nature described above.

Law. Section 214 (a-8) [Individuals) ; Section 234 (a-7) (Corporations). That 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, including a reasonable allowance for obsolescence;

Section 215. That in computing net income no deduction shall in any case be allowed in respect of

[Individuals] (b) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate;

(c) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made;2

The limitation on deductions by corporations (section 235) is the same as for individuals.

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'[Former Procedure] 1913 law. Individuals. “A reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business."

Section II B, Sixth. Corporations. “A reasonable allowance for depreciation by use, wear and tear of property if any." Section II G (b), 1916 law. Individuals. The words "or trade" were added.

Corporations. The words "and charged off” were inserted.

1917 law. Corporations. The words "actually sustained" were added. Section 12 (a), Second.

'Sections (b) and (c) are substantially the same as in the 1913, 1916 and 1917 laws.

In the regulations of the Treasury depreciation "applies to that which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence due to the normal progress of the art or to becoming inadequate to the growing needs of the business.”3 What may be termed ordinary obsolescence will be discussed in this chapter. Separate chapters in this book are devoted to extraordinary obsolescence and to depletion. It will be clear from the context whether depreciation is used in the inclusive or in the restricted sense.

Public accountants for many years have urged upon their clients the importance of ample allowances for depreciation, but the campaign has not been an easy one. The tendency is towards insufficient rather than excessive depreciation reserves. Edward N. Hurley, former chairman of the Federal Trade Commission, stated that “out of the 60,000 corporations that report an annual income of $5,000 or over, half do not charge off a single penny for depreciation.”

Depreciation is often treated as though no accurate estimate of the life of assets were possible, with the result that in some cases excessive reserves are created and in other cases there are no reserves at all. Perhaps the controlling reason for this variation of practice is a desire to utilize this as an elastic factor to bring about a desired effect on the balance sheet and the profit and loss statement. In some cases it is also felt that excessive book valuations may favorably affect the insurance adjustment in case of fire, but this fallacy is gradually losing ground. The recent improvement in methods of allowing for depreciation can be traced in large part to the installation of cost systems, which have brought about an increasing recognition of this factor as a necessary cost of production. Another powerful influence in the direction of accurate and adequate reserves has been the enactment of federal and state income and other tax laws calling for returns of net profits. Altogether there has recently been a general awakening to the fact that depreciation is a vital issue in correct accounting.

'Article 159 of Regulations 33, 1918, differentiated depreciation from “depletion, obsolescence and other losses."

'See Chapter XXX, “Deductions for Obsolescence," and Chapter XXXI, “Deductions for Depletion."

There are still wide differences of opinion as to the amount of the allowance which should be made from time to time. Many company officers prefer even yet to regard depreciation charges as flexible. They adjust them to meet the conditions of different years, so that in times of large profits the allowance is large and during bad years small. This, of course, is entirely opposed to sound accounting principles. If the business man passes over one year without making any allowance for depreciation, the result is a misrepresentation of conditions at the end of that year. 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. Net profit means only one thing in the vocabulary of the professional auditor-a meaning which should be universally recognized—and that is the excess of income over operating costs, expenses and losses. It cannot be determined by taking into account all the income and a part only of the charges against income. Full provision for depreciation must be included among the costs of operation, or the result may not be accepted as representing net profit. Statements, sometimes encountered in published reports, to the effect 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 are both misleading and illogical.

It is an unfortunate fact that the efforts of accountants to secure the establishment of proper depreciation reserves have in some respects been retarded and hampered by the attitude of certain inspectors in the administration of the income tax law. Part of the difficulty has been due to a mistaken general policy on the part of the government in favor of strict limitations on depreciation. In the first place, reserves for this purpose, if found in the future to be too large, will be ultimately taxable for any excess, and, in any case, the

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