Obsolescence as a Cause
The second factor of functional depreciation is obsolescence. By this we mean that lessening in worth which is brought about by the development of something new whereby production becomes more economical or is changed to meet new ideas, fads, or fancies of the consumer. Obsolescence may be imposed by outside forces through the exercise of the police power under circumstances analogous to those mentioned under the discussion of inadequacy brought about by external means. Municipalities and regulating commissions have speeded up the “irresistible march to the junk heap” in numberless instances. Cotton-spinning and shoe machinery, lasts and patterns of all sorts, electrical devices in particular—all have been subject to obsolescence charges. The horse car gave place to the cable car, which in its turn was displaced by steam locomotion, and today this has given way to electrically propelled street cars. The old wooden rail gave way to the rail of wood capped with a strip of steel, the light “T” steel rail, and the present heavy steel rails—changes all necessitated by changes and developments in the art and a demand for better service by the public. The stick used by the Indian to turn the ground and plant his corn has been displaced successively by hand tools of iron and steel, horse-driven plows, and the big steam and gas tractors of the present day. No industry has escaped the seemingly inevitable trend towards the displacement of the old and antiquated but not worn-out equipment, by newer, more up-to-date, and more economical equipment. Obviously the last word has not yet been spoken or the last refinement been made in the development or application of art and science to any industrial enterprise. Life means development; dry rot and retrogression are the fate of any art, any industry, any people which has reached the limit of its development.
Since, therefore, obsolescence is so common an occurrence, so absolutely a fact of general experience, it would be folly to ignore it. Many writers and some authorities have said that while obsolescence is as certain and ever present as the forces of nature, it seldom is more possible of measurement than are they. However, engineers tell us that in most cases it is possible for qualified experts to foretell with reasonable certainty the effect of obsolescence. “Those most familiar with the art know the units which will be able to serve their entire physical life, and what classes are so uneconomical or otherwise defective that some improvement must be expected.”
Treatment of Obsolescence
As to the effect of obsolescence, attention should be called to the fact that it is seldom operative to its full extent. The decision as to the exact time of discarding the old and installing the new rests on a nice balancing of many factors. Thus, the safety devices operated by hand on railroads are not displaced in a wholesale manner by those which operate automatically. In a large telephone company old switchboards are not discarded for new over the entire system at the same time. Much of the old is oftentimes allowed to serve out its life-term, and obsolescence has no effect. Under the circumstances stated above, and many similar and more complicated conditions, it requires a nice calculation to determine the actual effect of the factor of obsolescence in depreciation. Many inaccuracies, even many ridiculous conclusions, in estimates made by experts are met with, times without number. The novice thus fears even to guess as to the amount of the depreciation due to this factor. That is perhaps as it should be; there is no place here for the novice. Inasmuch, however, as the trend is to estimate the depreciation due to obsolescence, and such practice has the unqualified approval of many public service boards and at least the silent approval of our courts, it would seem that an attempt should be made to include it in the depreciation charge. As to its sufficiency or insufficiency, an amount can be estimated with as much accuracy under the head of depreciation as under that of a contingent reserve, and the former course is to be preferred in that an inevitable fact of experience in almost every industry is thereby recognized. The past, and not the future, is thus burdened with the accomplished waste. There doubtless will be instances where depreciation due to obsolescence palpably cannot be foreseen. For such there is but one of two courses, viz.: either to charge it against profits reserved out of the past, or burden the future with its cost.
Relative to the inclusion of obsolescence in the depreciation charge, the Illinois Public Service Commission says in the case of the City of Springfield v. Springfield Gas and Electric Company, March, 1916: “In view of all the facts in this case, the Commission finds that it is but reasonable, proper, and equitable to make deductions from cost new to cover accrued depreciation, both physical and functional....” The statement of the Maryland Public Service Commission in the case of the Chesapeake and Potomac Telephone Company of Baltimore City has already been cited on page 106. Quoting from the report of the Valuation Committee of the American Society of Civil Engineers: “A limited search ... indicated that inadequacy and obsolescence were included either in ascertaining the amount of depreciation to be included in cost, or to be deducted from earnings ... by the commissions of the following states: Arizona, California, Colorado, Illinois, Maryland, Massachusetts, New York, Oregon, South Dakota, Wisconsin.”
Covering this feature, i.e., the depreciation feature, in making returns to the government under the Federal Income Tax of 1916, the Commissioner ruled as follows: “The deduction for depreciation should be the estimated amount of the loss, accrued during the year to which the return relates, in the value of the property in respect of which such deduction is claimed, that arises from exhaustion, wear and tear, or obsolescence out of the uses to which the property is put.... The depreciation allowance, to be deductible, must be, as nearly as possible, the measure of the loss due to wear and tear, exhaustion, and obsolescence.”
Although not specifically mentioned, functional depreciation may be said to have the sanction of the United States Supreme Court in its decisions covering the Knoxville and Minnesota rate cases. In the case of the Des Moines Water Company v. City of Des Moines, 192 Fed. 193, September 16, 1911, the court allows both “functional and physical depreciation.”
It would seem, then, that the legality of the practice is pretty well established and the ability to compute the amount has been recognized. It is not often the case in matters of business policy and prudence such as this that the courts lead where business men and some professional men are reluctant to follow.
Contingent Depreciation