Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

The Factor of Idle Time

Were it possible to foretell length of service life in terms of units of product instead of units of time, a much better approximation to actual results would be secured. And this very thing is attempted under almost all methods of estimating depreciation. The life-period of the equipment is estimated on an assumption of average, normal use of the equipment—an assumption which will give good practical results when and so long as operations are normal or average. When, however, a period of depression comes and much of the equipment is idle, it is clear that that period would be burdened unduly with a depreciation charge based on years or months of service life. On the other hand, a period of feverish activity would not bear its just share of the burden of wasting assets. The period which is really overburdened must necessarily reflect it as an undervaluation of the assets—more has been charged off than has been used up; while the opposite is true of an underburdened period. Of course, on the theory of averages, by the end of the life-period of an asset all inequalities would be ironed out. Some methods of cost-keeping take this factor of intensity into account and spread the depreciation charge on a man-hour or machine-hour basis, which proportions it somewhat equitably to the product turned out by the use made of the machine and not to its elapsed life in days or months. The best that can be hoped for is as near an approximation to the truth as possible.

Depreciation a Means of Financing

Another view of the purpose of the depreciation charge is that it is a method or means of financing depreciation as it is sometimes termed. Under this view the effect of the depreciation charge on intermediate periods is lost sight of and it is used solely as a means of securing a sufficient contribution in hand at the end of the service life of the asset to finance its replacement. In other words, no attempt is made through the periodic depreciation charge to secure an accurate or necessarily true statement of the values of the assets, nor to see that the product of a given period is burdened with its just share of all costs, though this may be an incidental purpose. H. V. Hayes[27] in discussing this phase of depreciation says:

“It is argued that the plant unit ‘deteriorates’ year by year and that this ‘deterioration’ is the true measure of the ‘depreciation’ in the value of the unit during the intermediate years of its life, and, being a physical condition of the plant, can in no way be measured by the purely financial considerations upon which the reserves for depreciation necessarily must be based. Such a line of reasoning is absolutely faulty. Any attempt to reconcile ‘deterioration’ with ‘depreciation’ at any intermediate period in the life of the plant of an undertaking, is not only unnecessary but futile. The error in such an attempt arises from a failure ... to recognize the fact that ... if definite agreement has been reached as to the serviceable life (of the asset), the physical ‘deterioration’ of the unit, at any time during its life, can be a matter affecting its intrinsic value in no way whatever.”

Danger of the Financing Viewpoint

The above statement is a fair presentation of the case for depreciation as a financing device. It would seem, however, that the exponents of this view lose sight of the inevitable fact that the depreciation charge is pro tanto an evaluator of the wasting asset during the intermediate period of its life. Therefore a logical conclusion to be drawn from the view as expressed in the quotation above, would be the countenancing of any method by means of which provision could be made to replace the asset by the end of its life, no matter whether the charge was spread evenly over its life, was made all in one year, or was made to depend on the amount of the net profits at the end of a given year. This latter alternative is a dangerous policy, always to be deprecated, for depreciation is a cost of production to be taken account of before profits can be determined.

After all, it may be said without fear of serious contradiction that all three views, i.e., the engineering, the accounting, and the financing viewpoints, must be held in mind in any adequate treatment of the depreciation charge. The important point from the commercial and accounting standpoint is to secure a fair and equitable charge to each unit of product, regardless of whether or not the burdens of each fiscal period are equal. This is particularly evident when wear and tear from use is the effective factor in depreciation—and it is also contended that the factors of obsolescence and inadequacy may be as successfully and relevantly estimated in terms of business output as in years. If this results in an accurate valuation of the asset—and it is conceded that from the engineering viewpoint it may sometimes so result—the inaccuracy is of minor importance. According to the general law for the valuation of fixed assets, changes in the market need not and should not, as a general thing, affect the values at which the assets are carried on the books of a going concern. It is, of course, a corollary to the main proposition that this treatment also makes adequate provision for financing the fact of depreciation. Various methods and means for the accomplishment of these purposes are given in [Chapter IX].

The Standardization of Depreciation Rates

The determination of the rate of depreciation of a given asset is essentially an engineering problem. But as the accounting for depreciation is dependent on the rate, and the records of the accounting department must furnish much of the information for estimating the rate, the whole problem of fixing depreciation rates will be considered under the one head. Much study and effort to reduce all the conditions under which assets depreciate to a common basis and so to a definitely stated rate for each set of conditions, have, so far, come to naught and all qualified experts say without reserve that the rate of depreciation is an individual problem. It is to be hoped that a further gathering of statistics as to expectations of life of different assets under varying conditions will ultimately furnish tabulations, corresponding to insurance tables, according to which under known and expected conditions a fairly accurate rate of depreciation for a particular asset may be made. Unlike insurance rates, however, the depreciation rate once established will not necessarily remain constant, but must be subject to a periodic revision in the light of new data and conditions.