Decision of Supreme Court
The United States Supreme Court recognizes the necessity for an allowance for depreciation in Mayor and Aldermen of the City of Knoxville, Appt., v. Knoxville Water Co., 212 U. S. 14 (1909), which forms the basis of judicial attitude towards the question at the present time. The decision of the court which has been supported and reaffirmed in all subsequent decisions, reads, in excerpts:
“A water plant with all its additions begins to depreciate in value from the moment of its use. Before coming to the question of profits at all the company is entitled to earn a sufficient sum annually to provide not only for current repairs, but for making good the depreciation and replacing the parts of the property when they come to the end of their life. The company is not bound to see its property gradually waste, without making provision out of earnings for its replacement. It is entitled to see that from earnings the value of the property invested is kept unimpaired, so that, at the end of any given term of years, the original investment remains as it was at the beginning. It is not only the right of the company to make such a provision, but it is its duty to its bond- and stockholders, and in the case of a public service corporation, at least its plain duty to the public. If a different course were pursued, the only method of providing for replacement of property which has ceased to be useful would be the investment of new capital and the issue of new bonds and stock. This course would lead to a constantly increasing variance between present value and bond and stock capitalization—a tendency which would inevitably lead to disaster either to the stockholders or the public, or both.”
Recognition of the Depreciation Factor
Following this decision the rules and regulations of the public service commissions of practically all the states now require that provision for depreciation be made. In the case of some of the smaller public service companies the failure to make this provision is overlooked but the practice is generally recognized as absolutely necessary. The Interstate Commerce Commission has led in this respect, although its early rulings relative thereto were strenuously objected to in some quarters. Private concerns in their contact with the government now almost invariably see the value, or at any rate the self-interest, of a deduction for depreciation. In the case of the Special Excise Tax, a Treasury decision on account of Internal Revenue provides that “deduction on account of depreciation of property must be based on lifetime of property, its cost, value, and use, and must be evidenced by a ledger entry and a like reduction in the plant and property account with respect to which depreciation is claimed.”
Similarly, the present Federal Income Tax Law recognizes allowances for depreciation, but perhaps errs in placing too stringent safeguards on the amounts to be deducted therefor, whereas the Federal Trade Commission realizes the need of liberal provision. The law reads: “That in computing net income in the case of a citizen or resident of the United States, for the purpose of the tax there shall be allowed as deduction a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business or trade. No deduction shall be allowed for any amount paid out for new buildings, permanent improvements, or betterments, made to increase the value of any property or estate, and no deduction shall be made for any amount of expense of restoring property or making good the exhaustion thereof for which an allowance is or has been made.” The depreciation allowed as a deduction from income must have actually been charged off the books. Many interesting rulings—some almost absurd if carried to their logical conclusions—have been made by inspectors and the Treasury Department on points raised as to the application of the above law to particular cases. A perusal of these decisions will well repay the student who is interested in the subject.
Distinction between Repairs and Renewals
At this point attention is called again to the need of a careful distinction between repairs (up-keep and maintenance charges) and renewals (replacements and betterments). Only a clear definition of the terms and a strict adherence to an adopted policy can prevent endless confusion and absolutely misleading results. Such a policy is necessary because in the practical handling of such items on the books the theoretical aspect of the distinction between repairs and renewals must always be modified by reason. The student is referred to the preceding chapter where more detailed treatment of this point is given.
Depreciation and Plant Efficiency
The relation of depreciation to the efficiency of a plant or an asset will now be considered. The amount of depreciation is not based on the degree of efficiency of the service rendered by the asset. In other words, a depreciation reserve is not in any sense an inverse measure of the productive efficiency of the asset to which it relates, nor does the sum of all depreciation reserves either indicate or measure the degree of efficiency of the whole plant. A comparison of present with normal value (as defined above) affords some index of productive efficiency, but there is no direct ratio between the two. In any well-maintained plant, however, the normal value is the value below which the plant cannot be allowed to fall if the standard of efficiency is to be maintained; and good management requires nothing less than this. It has been variously estimated that normal value ranges from 75% to 90% of the original cost, and in some instances runs as low as 50%. The composite depreciation of from 10% to 50% represents the limit beyond which the decrease in value cannot pass if efficient service is to be given by the plant. Usually the sum of the depreciation reserves for all the assets of the plant remains fairly constant because the large reserves against assets that are almost ready to be scrapped are offset by the smaller reserves of the assets just replaced.