Group A assets, having been twice renewed, would be in 60% condition; Group B, 80%; Group C, 20%; and Group D, 40%.
Column (f) ÷ column (e), (175,000 ÷ 355,000 = 49²¹/₇₁%) gives the per cent of composite depreciation already taken effect.
The mean life, as determined above, multiplied by per cent of composite depreciation gives the mean age or portion of the mean life already lived (9⁷/₁₅ × 49²¹/₇₁% = 4⅔).
The figure of mean or composite life may serve two purposes. First, it forms the basis for comparison with other similar plants and is about the only fair basis for comparison. Second, it gives the basis for estimating the amount of annual depreciation of the plant as a whole. This statement does not mean that individual depreciation reserves are not to be carried for each group of assets and those charged with the value of the asset as soon as it is discarded and renewed. But the use of the estimated mean or composite life figure does give a control over the amounts which should always be found in the individual group reserve accounts, i.e., at any given time the sum of the individual reserve account balances should be approximately equal to the amount as shown by the reserve when calculated on the mean life basis.
The Reserve as an Index of Financial Condition
The statement is often made that a balance sheet showing depreciation reserves points to a conservative policy in the treatment of plant properties. Usually such a balance sheet affords little or no basis for expressing a judgment as to conservatism or the lack of it. All that it does show is that recognition is made of the fact of depreciation. As to its adequacy or inadequacy, a knowledge of other factors is necessary.
Fluctuating Reserve. According to successive balance sheets a reserve may vary little from year to year, or it may show considerable increase or decrease, and any of these conditions may be entirely normal and express adequacy of reserve requirements. In the first case, stability of the reserve may result because the asset is short-lived and hence is more or less frequently replaced; or different units of the property may have been installed at somewhat regular intervals so that retirements from service are also somewhat regular. Under either supposition, the charges against the reserve for the units displaced would just about keep pace with the regular credits to reserve for replacement purposes. In other words, that condition of the reserve for that class of asset is the normal condition—except perhaps in the case of a rapidly expanding plant, or other conditions not counted as normal when the reserve requirements were put into operation—and any other condition should lead to inquiry and investigation.
Increasing Reserve. In the second case where the reserve is showing a considerable increase from year to year, that also may be a normal condition. Long-lived assets are seldom replaced with any degree of regularity in the annual charge against the reserve, except in the case of very large plants where the number of such assets is correspondingly large in proportion to their size. Here more or less regular installations may take place as a result of an expanding business, covering a period of approximately the same length as that of the life of the asset. So here, too, any other than a regularly increasing reserve must incite inquiry.
Decreasing Reserve. As to the third case, that of a somewhat regularly decreasing reserve, the condition is not usually normal but may occasionally be met in a plant where one type of equipment is being retired and not replaced, due perhaps to a changing line of activity; as when, for instance, a stock furniture manufacturer works gradually into the exclusive manufacture of automobile and carriage bodies. Some types of equipment will thus be gradually retired and their reserves will constantly diminish, their place being taken by other reserves covering the new type of equipment. However, this condition of decreasing reserves, while entirely normal under certain circumstances, being unusual, should always receive careful investigation. It is here that mean life and mean age or composite plant depreciation are of assistance in forming a judgment as to the general adequacy of reserves.
The Reserve in Relation to Expanding Plant