Before considering the various elements of depreciation, an explanation of some related terms will be given. A distinction is sometimes made between “absolute or actual” and “theoretical” depreciation. Absolute depreciation is the decrease in value of an asset from its state when new, to its present condition as viewed either from the standpoint of the amount it could be sold for or from the standpoint of its serviceability. In the first place, therefore, absolute depreciation is not applicable to going concern valuations. A machine after only a short term of service becomes, from the standpoint of its salability, a second-hand article and suffers a large decrease in market value. A water-pipe or an underground telephone cable immediately after its installation and even before it is brought into service depreciates materially from the standpoint of its salability as a disconnected unit. But from the standpoint of service and operations, i.e., adaptability to its intended use, such an asset may really be more valuable than before or immediately after installation. Again, an asset because of the excellent state of repair in which it is maintained may, so far as the serviceability required of it is concerned, be practically as good as new from the date of its installation until well along towards the end of its life-term. Its actual or absolute decrease in value is very slight during the early years of its life but increases rapidly just before it is discarded. This fact is illustrated by the example of the water-pipe. Slight repairs, the replacement of parts and small units, keep it for a long period 100% efficient, but the time comes when it is completely worn out and repairs are no longer economically advisable. These two examples illustrate absolute or actual depreciation.
Theoretical Depreciation
Theoretical depreciation is based upon, and has reference to, all the factors which must be considered in taking account of depreciation. As so considered the subject is viewed from the standpoint of financing the item of depreciation (sometimes called “accounting depreciation”) rather than from that of its serviceability. The engineer attempts to determine the actual, present serviceability of the asset in comparison with its serviceability when new, and so he leaves out of account its expectancy of life due to whatever causes.
Comparison of Actual and Theoretical Depreciation
The following chart adapted from Henry Floy’s “Value for Rate-Making” admirably illustrates the difference between actual and theoretical depreciation.
Chart Showing Actual and
Theoretical Depreciation
Curves 1, 2, and 6 representing actual depreciation have been sufficiently exemplified in the foregoing explanation of actual depreciation. Curves 1 and 2 may well represent the actual depreciation of two assets as viewed from the standpoint of salability; whereas curve 6 represents the actual depreciation of an asset viewed from the standpoint of serviceability, assuming that maintenance has kept the asset practically 100% efficient during most of its life-term. Curves 3, 4, and 5 are illustrations of theoretical depreciation, the different curves representing different bases for calculating the annual amount of the decrease in value, as will be explained in [Chapter IX], “Depreciation—Methods of Calculating.” To quote from Mr. Floy’s work at length:
“The curves 3, 4, and 5 indicate several classes of ‘theoretical’ depreciation which have been quite widely used in some cases for estimating present values, but more often for determining the yearly theoretical deterioration for purposes of establishing depreciation funds, which, however, is quite a different subject. Making a theoretical estimate of the probable, future, average, annually accruing deterioration of certain property to provide an item in bookkeeping accounts of operating expense has nothing whatever to do, in making an appraisal, with fixing the definite amount of absolute, actual, or accrued depreciation which depends upon the present condition of physical property, determinable from inspection and not upon historical documents, depreciation funds, or disputed theoretical conclusions.”
In an opinion filed March 8, 1916, by the Public Service Commission of Maryland in the matter of the Chesapeake and Potomac Telephone Company of Baltimore City, an interesting commentary on the relative merits of actual versus theoretical depreciation is made. While the opinion concerns primarily depreciation from the rate-making point of view, it shows well the interrelation between the two kinds and answers so conclusively the objection often raised to accounting depreciation that it is here quoted. The statement is: