Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

Aspects of Depreciation

Depreciation is intimately related to practically all problems of valuation. The engineering profession has made many valuable investigations and contributions to the literature of the subject and constant reference to them and use of some of their findings will here be made. Most of their studies relate to the vexed and still unsettled question of the valuation of public utility properties for the sake of its bearing on the problem of fair and equitable rates to the user or consumer. Accordingly much of this material is not applicable to the accounting phases of the subject. It is purposed here to treat the question from the standpoint of accounting rather than that of engineering.

Depreciation may be considered from many viewpoints. It is involved in the problem of rate-making referred to above; it must be considered in the valuation of fire insurance adjustments; it is bound up with most questions of taxation, with all transactions involving the purchase and sale of enterprises, with negotiations for the procuring of loans, for the determination of the limitation of capitalization; and in all studies of commercial balance sheets depreciation is found to affect the value of going concerns. As stated in Chapter V, these are not always separate and distinct problems of valuation; they may and often do overlap, one basis for valuation sometimes serving several of the purposes or classes named above. The treatment of the subject will be limited in this book to the latter phase of the subject, i.e., going concern valuation, with the object of establishing certain norms and differentiating this phase of depreciation clearly from its other relations.

Definitions

A clear-cut definition of depreciation is desirable. The word in a general sense means a lessening, a decrease in value; decretion; deterioration. Various specific definitions are given, among them being: “the loss, arising from years of service, in the value of the investment in perishable property”; “expired capital outlay.” These and many other similar definitions are met with.

The term “depreciation” is frequently used when the term “amortization” would be more appropriate. R. P. Bolton[14] says: “The subject of depreciation has been greatly misrepresented, because depreciation, which is a financial result, has been confused with obsolescence, which is an economic process, and with deterioration, which is a physical condition. Either of the latter brings about depreciation, and the physical process rarely happens to be more rapid than the economic.

“An illustration of the processes involved is that of the physical deterioration and obsolescence of a work horse, the capacity of which is definitely connected with its condition, and the value of the labor of which is discounted by its up-keep and the cost of its supplies and feed. Its age is productive of reduction of capacity, but this process may be, and often is, anticipated for commercial reasons by its supersession by some other form of apparatus. The horse may be in ever so good a condition at the time when the motor displaces it, but its financial depreciation then is complete, for it could be maintained only at a loss. All the elements which come into consideration in connection with machinery will be better understood if considered in relation to such an animal, the life of which may readily extend beyond the point at which its commercial value has terminated.”

Authoritative Opinions

The special committee appointed by the American Society of Civil Engineers for the purpose of formulating principles and methods for the valuation of railroad property and other public utilities, after a study of the question covering a five-year period, presented its report at the annual meeting of the society, January 17, 1917. The question of depreciation receives full and serious consideration in this report, which although treated mainly from the rate-making standpoint offers many suggestions for the valuation of commercial balance sheets. Their statement reads:

“Perhaps there is no single subject in connection with valuation that has caused more trouble than depreciation. This has been due to various causes, perhaps not the least of which has been confusion in the use of the term. Depreciation is sometimes used to mean decretion, which is loss of service life; sometimes to mean the money allowance made in the bookkeeping to offset accruing loss of service life; and sometimes the loss of value existing at any time due to the loss of service life or any other cause. The committee will use it only as meaning the loss of value or worth of property units which are parts of going concerns. Although this may be due to many causes, the general discussion will include consideration only of those effects which, like wear and tear, age, use, and obsolescence or inadequacy, bring a physical property unit gradually to the end of its service life.”