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after the machines have been used from six to eight years. An annual depreciation rate of 20 per cent is conservative.

Wagons, trucks, etc.—In the case of wagons it will be found that 8 to 10 per cent per annum is an ample allowance, provided that all repairs, renewals of parts and maintenance are charged to operating expenses.

Wood-working industry. On buildings and equipment in the wood-working industry the depreciation is low-about 2 or 3 per cent on buildings and 6 per cent on equipment.

CHAPTER XXX

DEDUCTIONS FOR EXTRAORDINARY
OBSOLESCENCE AND AMORTIZATION

Federal income tax laws prior to 1918 contained no reference to obsolescence and amortization but conditions in 1918 required that explicit authority should be given to the Treasury to grant and to taxpayers to deduct adequate allowances for losses which might not otherwise be permitted.

Ordinary obsolescence is usually merged with depreciation and is discussed in the preceding chapter. In this chapter extraordinary obsolescence and amortization will be considered.

Obsolescence

LAW. Section 214. (a) That in computing net income there shall be allowed as deductions: ....

(8) A reasonable allowance for .... obsolescence;

The Treasury prior to 1918 allowed as deductions realized obsolescence. As such deductions could have been made as losses whether or not obsolescence as such was specified in the law, the reason for the specific mention of obsolescence in the 1918 law was to permit the accrual of obsolescence "so as to allow for such future obsolescence as may be expected from experience to result from the normal progress of the art."

Under the most recent rulings so-called "ordinary obsolescence,” viy , that obsolescence which is accruing but which cannot be definitely ascertained, is to be included in the annual depreciation allowances rather than in a specific reserve for obsolescence.

*This section deals with individuals. Section 234 (a-7) applies the same language to corporations.

'Reg. 45, Art. 166.

REGULATION. A reasonable allowance for the exhaustion, wear and tear and obsolescence of property used in the trade or business may be deducted from gross income. For convenience such an allowance will usually be referred to as covering depreciation, excluding from the term any idea of a mere reduction in market value not resulting from exhaustion, wear and tear or obsolescence. .... (Art. 161.)

Obsolescence as described above has been discussed in the preceding chapter. Obsolescence which may be said to be "realized” is considered in the following pages.

The foregoing regulation accords with proper accounting methods. Depreciation allowances set up by conservative concerns were always supposed to be sufficient to include adequate provision for ordinary obsolescence. “It follows that in fact deductions were made for obsolescence.” The law now definitely sanctions the deductions which taxpayers have been making and the Treasury has been allowing for some years.

Treasury Procedure as to Obsolescence Under previous laws the Treasury allowed as deductions reserves for depreciation, but did not allow reserves specifically for obsolescence.3

'[Former Procedure] Basis for deduction-cost less depreciation and salvage:

REGULATION. "Amounts representing losses on account of obsolescence of physical property may be included as a deduction from gross income as a loss, provided such amounts have been recorded in the books following the condemnation and withdrawal from use of the obsolete property. The amount of obsolescence that may be claimed as a deduction shall be ascertained by deducting from the cost of the property the total amount that has been previously claimed and deducted on account of the depreciation of the property, plus the residual value at time of obsolescence, or plus the amount received for the sale of the property. The obsolescence deduction must not include the accumulated depreciation applicable to prior years." (Reg. 33, 1918, Art. 178.)

Obsolescence determined after segregation of depreciation:

REGULATION. "If no depreciation has been charged off against such property and deducted from gross income of prior years, the amount allowable as a deduction for the year in which the property becomes obsolete shall be ascertained by deducting from the cost of the property its residual value plus an amount equal to the depreciation actually sustained during the prior period and which might have been

Reserves for obsolescence which appeared on taxpayers' books at the beginning of the taxable year ending in 1918 were not allowable as deductions under earlier income tax laws. In order to avoid great annoyance and possible complications in the future it would be proper in most cases to transfer obsolescence reserves as of January 1, 1918, to surplus account. Commencing with that date, obsolescence reserves should reflect allowances claimed and allowed for income tax purposes.

Duplicate deductions must be avoided.—No well-regulated concern would charge off the same item of plant or equipment more than once, but on this point the law contains a special warning. Care must be taken that any allowances for depreciation or obsolescence or amortizations claimed and allowed in returns for years prior to the taxable year be not claimed again. This, however, does not apply to amounts claimed in previous years but not allowed.

Present Accounting Practice as to Obsolescence

The author believes the position assumed by the Treasury in regard to obsolescence prior to the enactment of the 1918 law was essentially sound. He is not prepared to support the contention of certain accountants that extraordinary obsolescence, like depreciation, is an item of prime cost.

To the extent that an allowance for ordinary obsolescence has been merged with depreciation it is entirely proper to charge the combined allowance to operating expenses. The attempt to anticipate extraordinary obsolescence should be from profits and not from current income.

deducted when computed at the rate applicable to the same or similar property. The amount of depreciation thus arrived at as applicable to former years may be made the basis of amended returns and a claim for the refund of taxes overpaid by reason of the fact that no depreciation deduction was claimed in those years." (Reg. 33, 1918, Art. 179.)

'Law, section 215 (b), (c).

•See Auditing, Theory and Practice (2nd edition), by R. H. Montgomery, page 224.

Uncertainty of obsolescence.-Ordinary depreciation is certain and cannot be avoided any more than death or taxes. It accrues from day to day. One can see it. Obsolescence when applied to the future (there is no difference of opinion as to the treatment of known obsolescence) is a matter which requires more careful estimates than depreciation. No one knows when it will come. In some cases, where expected, it has not materialized. In many instances, where not expected, it has come almost at once. It is true that it has occurred in the past on a great scale. Most modern machinery has superseded other machinery which was not worn out, and many a plant, only ten years old, that counted on a twenty-year life for its equipment for which a depreciation reserve was set up on that basis, has not been able to renew the machinery out of the reserve. It is also true that in view of the rapid strides in all the mechanical sciences, obsolescence is likely to continue indefinitely to be a serious factor in the ultimate cost of producing manufactured goods. Unevenness of practice should be avoided. One man should not be permitted to guess that his machinery, having an estimated effective life, under normal conditions, of ten years, will become obsolete and have to be replaced within two years. Nor should another, owning the, same kind of machinery, be permitted to make his guess four years. The makers of the machinery might testify that it would perform full service for ten years. When claims for obsolescence are reasonable they should and will be allowed. When unreasonable the claimant deserves to be penalized.

Conflict of opinion as to proper practice.-Some accountants flatly contend that it is practicable and desirable to provide for all obsolescence allowances as operating expense. Others, impressed by the fact that obsolescence frequently represents a large item of cost or expense, while not wishing to include it as a direct operating expense, desire to provide for this charge at a point in the accounts before an operating or net profit is shown. Against this it is argued that if obso

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