Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

2. Funds may be borrowed.

3. Profits of the past may be reserved in the business and the actual value of the holdings of the owners thus be enhanced.

In the third case present dividends may be sacrificed for the sake of the future. Such reserve profits must be kept and used for the intended purpose, the purpose dictating their form as liquid or fixed. It cannot be too strongly emphasized that these are reserves of profits—not valuation or offset accounts under the title of reserves. Depreciation reserves, except they become secret reserves in the sense referred to below, have no right to serve any other purpose than that intended, viz., to provide insurance that none of the originally invested capital shall be dissipated and that the current product shall be burdened with its just share of all the materials and costs of production.

Secret Reserve

A great deal has been said about inaccuracies in the depreciation charge; the need of periodic readjustments has been emphasized. Now it is purposed to look into the effects of inaccurate charges remaining unadjusted on the books. In a desire to be on the safe side, some concerns, notably financial institutions, make very liberal provision for depreciation. Such a policy is not entirely to be condemned and is decidedly refreshing in comparison with the parsimonious allowances, begrudgingly made in some quarters. The effect of such a policy, if operated without check, is to create what is known as a “secret reserve.” The value of the asset is charged more rapidly against operation than the asset actually wastes. Hence the books show a reserve sufficient to cover the cost of asset while there are still values remaining in the asset. In other words, the business possesses an asset of value which is carried on the books as of no value. Were the real present value of the asset brought on the books, the contra credit would appear in some surplus or profits reserved account. Such would constitute a true record of the item, openly stated. So long as the asset remains concealed, i.e., without record on the books, its contra credit is also latent and constitutes a secret reserve of profits.

A too liberal depreciation policy, if recognized and adjusted at the time of a reappraisal, will require a separation from the depreciation reserve of the portion brought about by the overallowance, and its showing as a part of the surplus. When so handled, an overcharge for depreciation has no permanently bad effect except as it may show, for purposes of comparison, too high costs of production for the period overburdened. However it may be and sometimes is, used for purposes of fraud and therefore, as a fixed policy, the practice of the secret reserve is to be condemned.

Insufficient Charge

On the other side is the parsimonious policy of too low a charge or none at all. This results, whether consciously or not, in a charge against capital instead of revenue. At the close of the fiscal period the books are supposed to be brought into accord with the facts of true condition as then existing. Therefore, if the full portion of the accrued expenses is not separated from the wasting asset accounts, but is allowed to stand on the books under the title of assets, then these true expense items will still be carried hidden under the cloak of asset titles. The depreciation is thus carried as a charge against capital. The depreciation of a going concern should never be so treated; it is an operating charge, and no flight of fancy or shuffling of figures can make anything else of it.

In the case of a property, showing inflated values because of too low depreciation charges in the past, which is taken over and rehabilitated, the sums spent on the property previous to operation to put it in condition are properly capital charges. This is allowed on the theory—unfortunately, not always a fact—that the difference between the book value of the property and what was paid for it represents the estimated expenditures necessary to bring the property up to its book value. If such is not the case and full book value was given for the property, the charge is still allowed, being looked upon as in the nature of an organization expense, representing in an instance of this sort the measure of the bad bargain made. This will, of course, result in a penalty in the form of an added depreciation burden on all product from the property taken over and rehabilitated.

Appreciation as an Offset to Depreciation