Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

In the case of a plant the development of which is stationary, the problem of judging the adequacy of the reserves is simple in comparison with a plant which is expanding, resulting not only in the installation of more of the same kind of equipment but also of equipment of other kinds. A disturbing element is thus introduced and careful oversight of the depreciation policy must be exercised. In all cases, intelligent reading of the reserve and its sufficiency are internal problems based on intimate knowledge of conditions. Lacking this knowledge no true judgment can be made. The character of the asset, number of units in use, dates of installation, a comparison of the assumed conditions at date of installation with the actual conditions of the present—all are factors to be taken into account.

Reserve as Related to Efficiency

The general relation of efficiency to depreciation has already been discussed. As to whether the condition of the reserve is any index of the efficiency of the service rendered by the plant unit, attention is briefly directed to a misinterpretation of individual reserves. Experts state that many types of equipment cannot deteriorate actually more than a fixed per cent of their cost and continue to give efficient service. If, say, 30% is the limit in the case of one type, this does not, of course, indicate that, as soon as the depreciation reserve shows an amount equal to 30% of the cost, the approach of inefficient operation and the time of discard are at hand. It must be borne in mind that the reserve is a device based on financial considerations and, if properly calculated and handled, no asset should be ready for retirement until its reserve approaches in amount the value at which the asset is carried in its account. Nor is the point of approaching inefficiency shown until that condition of the reserve is found.

Reserve not Based on Cost of Replacement

The question is sometimes raised as to whether reserve requirements should be based on original cost or cost of replacement new. The question usually reveals a lack of understanding both of the purpose of the depreciation charge and the means of financing depreciation. It is usually said that the reserves carried on the books are for the purpose of providing the means of financing the replacement. It is not the purpose here to go into the question of original cost versus cost of reproduction new, either as a basis for valuation of public utility properties or from the viewpoint as to where the incidence of the burden of replacement properly should rest—whether on the users of the service given by the asset to be replaced or on those using the new asset. In the private enterprise where the rights of the public are not so apparent, under present-day tenets of political and economic philosophy, only internal policies and purposes to be accomplished need be considered.

As stated above, the basic purpose of the creation of the reserve is to burden the product with depreciation charge as a real part of the cost of production. If we are concerned with real and actual costs of production, by no stretch of the imagination can replacement cost—what it might cost to replace the asset at some more or less distant time—enter into the question. It might, with equal obscurity of logic, be said that, because the labor cost is bound to be higher 10 years from now than at present, in order to get the true present cost of the product the estimated future labor cost should be taken in place of the actual present cost.

The Financing of Replacements

If one purpose of the depreciation reserve is that of financing depreciation, this can mean only that the reserve must insure provision being made so that the capital invested will not be lessened or encroached upon by the wasting of the assets in which it is invested. It is no necessary or proper purpose of the reserve to provide for increasing the invested capital. Financing the replacement of the retired asset is a separate financial problem and only concerns accountancy, so far as the records may reflect that policy. The reserve, in itself, does not furnish the means of financing any part of replacement, as was fully shown above. If the new asset is expected to cost more than the old, certainly business prudence would dictate provision for the added cost as well as ready funds of an amount equal to the original cost. The actual capital provided originally need be sufficient only for the time being; to provide more than that, if remaining idle, would be folly. If there is evidence of expansion, or if it is recognized that more will be needed—due to change in markets—for replacement purposes than was originally needed at the inception of the enterprise, provision must be made therefor.

Methods of Financing Replacements. In the financing of replacements, three courses are open:

1. Capital stock may be increased.