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

lescence cannot be reduced to enough of a certainty to make a periodical allowance for it, there is a strong reason for omitting it as an element of prime cost. If it can be estimated closely enough to set aside a definite amount, the author thinks it should be called depreciation rather than obsolescence. If a close estimate cannot be made the allowance should go in the accounts as an extraordinary expense, rather than as an ordinary operating expense.

Extraordinary obsolescence.-The foregoing relates to socalled "ordinary obsolescence." The regulation as to extraordinary obsolescence is as follows:

REGULATION. When through some change in business conditions the usefulness in the business of some or all of the capital assets is suddenly terminated, so that the taxpayer discontinues the business or discards such assets permanently from use in the business, he may claim as a loss for the year in which he takes such action the difference between the cost or the fair market value as of March 1, 1913, of any asset so discarded (less any depreciation allowances) and its salvage value remaining.

PROOF REQUIRED.—

This exception to the rule requiring a sale or other disposition of property in order to establish a loss requires proof of some unforeseen cause by reason of which the property must be prematurely discarded, as, for example, where machinery or other property must be replaced by a new invention, or where an increase in the cost of or other change in the manufacture of any product makes it necessary to abandon such manufacture, to which special machinery is exclusively devoted, or where new legislation directly or indirectly makes the continued profitable use of the property impossible.

WHEN NOT APPLICABLE.

This exception does not extend to a case where the useful life of property terminates solely as a result of those gradual processes for which depreciation allowances are authorized. It does not apply to inventories or to other than capital assets.

WHEN APPLICABLE TO BUILDINGS AND MACHINERY.The exception applies to buildings only when they are permanently abandoned or permanently devoted to a radically different use, and to machinery only when its use as such is permanently abandoned.

MUST BE CHARGED OFF.

Any loss to be deductible under this exception must be charged off on the books and fully explained in returns of income. . . . . (Art. 143.)

....

EXTRAORDINARY OBSOLESCENCE DUE TO PROHIBITION.As stated in the foregoing regulation (article 143), an exception to the rule "requiring a sale or other disposition of property in order to establish a loss" is made "where new legislation directly or indirectly makes the continued profitable use of the property impossible."

A concrete illustration of loss occasioned by new legislation is that caused by state and national prohibition. When the slavery question was a live issue there were many who thought that slave owners, who had vested property interests in slaves, should not be deprived of their property without compensation. Likewise there are many who think that those who have acquired property rights in the liquor business should not be subjected to loss without compensation.

As with the slavery question, public sentiment is opposed to governmental compensation for losses sustained by the liquor interests, but when property losses due to prohibition. are established those sustaining the losses are entitled to deductions therefor in their income and excess profits tax returns.

Allowable losses include goodwill and other intangibles but the deduction is limited to fair market value March 1, 1913, or actual cost since that time.

RULING. Receipt is acknowledged of your letter of March 12, 1919, in which you request a ruling to the effect that distillers and dealers in liquors may for the year 1918 take a reasonable amount for obsolescence of goodwill, trade-marks, and trade-brands, the value of which has been impaired or destroyed by prohibition legislation. In reply you are advised that a reasonable allowance for obsolescence of such assets may be taken by distillers and dealers in liquors against earnings between November 21, 1918, the date upon which the Agricultural Appropriation Act, providing for war time prohibition, was enacted, and July 1, 1919, the date upon which the war time prohibition is to become effective."

"For modification of period during which obsolescence can be charged, see page 747.