Accounting Principles – Depreciation

All physical assets are constantly undergoing deterioration as time passes. With some assets it is more marked than with others. It is rather difficult to recognize deterioration in the case of a desk. It is easier to recognize it in the case of an iron pipe which is exposed to the weather. It is, nevertheless, true that, although unobserved, deterioration is constantly taking place. On the other hand, man, through the use of physical assets causing what is known as wear and tear, is constantly decreasing the value of said physical assets. In a similar way he seeks, through invention, to find newer and better machines and articles of equipment for the manufacture of goods and transaction of business. The business man naturally turns to that which is newest and best, laying aside, perhaps, that which has served him faithfully, because of the saving either in money or energy through the use of the new invention. It is said of Mr. Andrew Carnegie that he owes his success in a very large measure to his ability to recognize new machines and his courage in casting aside machines which had thus become obsolete. The dictionary defines obsolete very simply and specifically as something which has “gone out of use.”

The recognition of the existence of depreciation may be regarded as a somewhat recent one. Until a comparatively short time ago accounting practice did not take into consideration the element of depreciation. That it is an important element, and cannot escape recognition, is borne out by the many litigations that have arisen in the last quarter of a century. In the case of Conville v. Shook, et al. (24 N. Y. Supp. 547, 1893), the action was to recover the sum of $6,779.40 by the plaintiff from the defendant for the former’s share of the profits of the business for a given year. The defendant claimed that the plaintiff’s share of the profits during the year in question was greatly less than the sum claimed by said plaintiff. Testimony was introduced by an accountant to the effect that numerous items were improperly entered on the books, the sixth one of which was depreciation of the original plant. It appears to have been the practice to provide for depreciation at the rate of 10 per cent. per annum. In that way assets originally costing $45,000 had been reduced at the time of accounting to $29,309.45. It was held by the court that there was no reason why the original plant should have been carried on the books for ten years at the original cost. The charge for depreciation was sustained.

In the case of Emery v. Wilson (79 N. Y. 78), Emery, Wilson and a third party were copartners, sharing in the profits one-tenth, four-tenths and five-tenths, respectively. Upon the death of one of the partners, namely, the third party mentioned, an action was brought for the accounting and settlement of the copartnership affairs. A question as to whether it was proper to allow for depreciation in the value of the property in ascertaining the profits arose. The referee apparently refused to permit an allowance for depreciation, and was sustained by the court.

In the case of Tutt v. Sand (56 Ga. 339), it appears that Tutt and Sand entered into a copartnership whereby Sand, the defendant, was to furnish the stock of goods then on hand, and the plaintiff, Tutt, was to render his skill, services, etc. The former was to have three-fourths of the profits, the latter onefourth. The partnership was dissolved, and the plaintiff brought an action for $10,000 as his share of the profits which had been made. The defendant sought to set off against this amount various claims and expenses, among which was an item of $4,098.11, covering a depreciation of 10 per cent. on merchandise. In this case it appears that the item of depreciation was not allowed to stand as an individual matter between the partners, or, in other words, as a set off, but was properly included as an expense of the business, and borne jointly by the two partners.

In the case of the San Diego Water Company v. City of San Diego, the plaintiff was a corporation engaged in the business of supplying water to the city of San Diego and its inhabitants. The Common Council of the city passed an ordinance fixing the water rate for the year. The plaintiff sought to annul the ordinance on various grounds, one being that the rate so fixed would be insufficient to pay its operating expenses and fixed charges, and, therefore, afford no reward to the plaintiff for furnishing water, which would be depriving the plaintiff of its property without due process of law and without compensation. The water company appears to have sought to include as an item, in making up the cost on which the rate was based, a sinking fund provision for depreciation. The court held that no percentage upon the investment could properly be charged as a sinking fund, to be added to the operating expenses, as a general provision against depreciation of the plant through use.

In a similar case, namely, the Redlands Water Company v. the City of Redlands (121 Cal. 312), the city likewise adopted an ordinance fixing the rate. The water company brought an action to annul the ordinance on the ground that the rate would be insufficient to enable it to pay the interest on its indebtedness, its operation expenses and taxes, and for keeping its plant in repair. It was held by the court that the water company was not entitled to have the rate so fixed as to enable it to set apart a certain amount each year as a sinking fund for the depreciation of its plant.

In the case of Whittaker v. Amwell National Bank (52 N. J. Eq. 400, 1894), one of the questions at issue was whether or not dividends declared and paid by the Star Rubber Company, one of the defendants in this suit, were paid out of the surplus or net earnings of the company. It was held, among other things, that this could only obtain by taking into account the cost of repairs and a reasonable allowance for depreciation for wear and tear. The court said: “It cannot be successfully contended that all such machinery is not subject to depreciation from wear and tear or actual use. That all machinery does not suffer alike is equally plain. The testimony in this case leads me to the conclusion that the depreciation was at least 2 per cent. a year.”

In one of the most recent cases, namely, Cumberland Telephone and Telegraph Co. v. City of Louisville (187 Fed. Rep. 637, decided April 25, 1911), the question of depreciation arose in a suit brought by the telephone company to enjoin the enforcement of an ordinance as confiscatory and unconstitutional. In this case the court took cognizance of depreciation, and said: “We define depreciation to be the loss in value of some destructible property over and above current repairs.” There was involved in this suit the question of what proportion of the company’s annual earnings shall be set aside for making good the depreciation and replacing the parts of the property when they come to the end of their life. This question was one altogether apart from and beyond current repairs. On this question the court ruled as follows: “A reasonable amount to be set apart in this climate for making good depreciation is 7 per cent. of the value of the fixed plant, exclusive of real estate, working capital and supplies in hand. The testimony clearly leads to the conclusion that the average life of the combined elements which make up the plant is about fourteen years, and we shall proceed upon that theory. In estimating depreciation, we will reckon it at 7 per cent. of $1,575,000, the value of the destructible parts of the plant. Of course, our estimate cannot be based upon the proposition that the per centum set apart to cover depreciation would be deposited in banks or loaned out from year to year, so as to accumulate, and be, at the end of fourteen years, used to construct an entirely new plant. In such a case the public would not only have a service that would grow worse when its operation ceased altogether, but it would thereafter get no service at all until a new plant, replacing the old, could be completed and put into operation.”

It will be seen from the last-mentioned case that it is one of the latest and most modern rulings on the subject. It will also be noted, in glancing over previous cases, that while there have been some decisions which refused to recognize the element of depreciation the tendency at the present time is toward a general recognition. The Interstate Commerce Commission and the various Public Service Commissions have done much to establish this recognition.

Regardless of legal decisions, it must be borne in mind that depreciation is a very important item, since no matter what the type of organization may be, or what the nature of the business, the net profits will be affected in accordance with whether or not depreciation is allowed to enter into the accounts. It seems that it must be considered as conclusive that physical property does depreciate in value, and that if such depreciation takes place it is a proper charge against the expense of the period. If this is true, and depreciation has not been included as an item of expense, then the net profits are incorrectly stated. Hence the importance in all contracts of copartnership, and similar contracts, of recognizing and providing for depreciation in the stating of the accounts. To illustrate this point concretely, suppose that a certain firm should acquire a parcel of land, including a building, at a cost of $25,000. Assume, if you like, the copartnership to continue for thirty years. At the time of dissolution assume that in the distribution of the assets A elects to take the property at its cost, namely, $25,000. Assume further that the property is so situated that there has been no perceptible appreciation in the value of the land, and that the former partner, A, now attempts to dispose of the property, and is suddenly confronted with the fact that it will not bring more than $10,000. The injustice and inequality of having failed to provide for the depreciation of this property before the copartnership accounts were stated, and the affairs settled, will be very evident.

Admitting the necessity for depreciation, it must then be observed that it will vary in different localities with regard to the nature of the assets, the use to which they are put, and the kind of use which they receive. It will be recalled in the case of Whittaker v. Amwell National Bank the court was led to conclude that depreciation was at least 2 per cent. a year, while in the case of Cumberland Telephone and Telegraph Company v. City of Louisville depreciation was allowed at the rate of 7 per cent. a year. The question may be asked, Why this wide variation in rates? While the cases do not show specifically the kind of property involved, it is probable that, making due allowance for failure of the courts to employ a scientific rate established by experience, there was some marked difference in the nature of the asset or the use to which it was put. Obviously, the rate of depreciation upon a dwelling which receives careful use at the hands of its occupants will not be as high as that for a taxicab which is being constantly driven about the streets, over rough pavements, at a high speed. As a matter of further illusration, a case of boilers may be mentioned. In the southwestern part of the United States especially, where the water contains a great amount of alkali, the boilers will scale and need replacement at least five times as often as in the northeastern New England States, where the water has little effect upon boilers. To charge the same rate of depreciation in both places would be entirely incorrect. In the same way, buildings containing heavy machinery, and which are subject to constant and marked vibration, will depreciate much faster than buildings wherein no such machinery is found.

Experience only will determine the proper rate of depreciation to be used in each particular case. Appraisal companies have probably the best detailed information on this subject in the country. Since this information constitutes in part their stock in trade they are loath to make it public. That the variations in rates are great will be seen in consulting tables such as those compiled by Mr. George A. Cravens (published in The Electrical Review, April 23, 1910, and reproduced in Montgomery’s “Auditing,” page 325), in which depreciation of boilers is seen to fluctuate from tfA to 10 per cent. per annum. Mr. H. S. Tiffany, in his book called “Digest of Depreciations,” which is probably one of the most complete tables extant, places the average life of a boiler at ten years, and therefore computes the depreciation at 10 per cent. Mr. Tiffany’s note bearing on the use of the property, as follows, is interesting: “In giving the percentages of depreciation on engines and boilers it is assumed that a careful and competent engineer is employed, and that they are well cared for. Where this is not the case the per cent. is largely increased, and many cases have been known where in less than five years they have been, through carelessness, rendered entirely useless, and consequently worthless.”

While attention is usually given, in so far as depreciation is concerned, to buildings, equipment, etc., very little attention is ever given to the depreciation of land. It is usually assumed that land does not depreciate. This is probably true with regard to all land except that used for agricultural purposes. Mr. R. H. Montgomery, in his book on “Auditing,” calls attention to the fact that “land used for agricultural purposes may depreciate through use, and does depreciate unless a certain rotation of crops is followed, or unless fertilizers are used. The latter is equivalent to the cost of maintenance and repairs in a factory. The price of flaxseed has increased enormously because during the early years of farming in the West the vitality of the land was exhausted by raising a crop which impoverished the soil to such an extent that farmers were obliged to discontinue the raising of flaxseed. During this period, when this crop was using up the value of the land, the farmers should have set up a reserve for depreciation, and it would have been apparent that the net price realized from the flax crop was not nearly so high as it seemed, but that wheat, while bringing in less per acre, would have been more profitable. Heretofore, text-books on auditing have stated, without qualification, that land does not depreciate. If it is a fact that three-fourths of the land in the United States is depreciating through use, these statements should not have been allowed to go unchallenged so long.”

Another important matter to be kept in mind in connection with depreciation is its relation to repairs. Most authors agree that depreciation is something quite apart from repairs and maintenance. It is true that if an asset is repaired and maintained it will last longer than if such is not the case. It should be borne in mind that in estimating the life of a given asset allowance must be made for a reasonable amount of maintenance and repairs. If repairs are neglected the life of the asset will be shortened. If the asset is thoroughly maintained its life may be lengthened. The point which the author is especially anxious to bring out is the fact that rates heretofore and hereafter mentioned exclude any provision for repairs and maintenance; that the depreciation takes place quite apart from the charge to expenses which is made for repairs and maintenance.

Before proceeding to a discussion of the various methods of computing depreciation some attention should be given to the bases on which it is computed, namely, the cost of the asset, its estimated life, and the residual value. Most assets, whatever their life may be, will ultimately have a scrap or residual value. This is, of course, at best an estimate, the same as the life of the asset is an estimate. The existence of the residual value should be recognized and an attempt made to fix it as well as possible. If the residual value is recognized, it is apparent that before the amount which is to be charged off or depreciated can be ascertained the residual value must be deducted from the original cost. The result then is the amount which is to be spread over the estimated life of the asset.

With regard to the methods employed in computing the annual rate at which depreciation may be charged to the operating expenses there are two which are worthy of special mention, as being entirely practicable, whereas several others may be discussed merely as a matter of interest. Most authors, writers and authorities recognize three different methods, namely: (i) the fixed percentage of the original value, or the flat rate, as it is frequently called; (2) the fixed percentage on balances, or the reducing scale basis; (3) the sinking fund. Some authors mention an increasing scale, while others suggest not a percentage at all, but depreciation determined by revaluation at inventory periods. It is also true that mining companies base their depreciation, or, in reality, depletion, on tonnage, charging off five or ten cents, or whatever it may be, per ton, in accordance with the number of tons extracted. This same basis might also be used in the case of a foundry furnace, the lining for which is constantly being exhausted, and is wearing out in direct proportion to the number of tons of molten metal which pass through it. Of the various methods mentioned, the fixed percentageAis probably the most practicable and easiest of application. It contemplates dividing the original cost, less the residual value, by the estimated number of years of life and charging off a corresponding percentage each year. In this way the depreciation is spread equally over the life of the asset. The reducing-scale method is advocated by adherents who claim that repairs and maintenance are heaviest during the latter part of the life. They contend, therefore, that in order to secure an equitable charge against the profits of the respective periods a larger amount, steadily decreasing, should be charged against the earlier years of the life, whereas a smaller amount should be charged during the later years, when the maintenance is steadily increasing. It must be conceded that there is considerable merit in this contention, and it is, perhaps, not any more difficult, after the first mathematical calculation has been made, than the first method suggested. The practical objection to it is that the ordinary layman is not sufficiently familiar with algebraic formulae to determine the percentage. The fixed percentage on original cost is the layman’s way of computing depreciation.
With regard to the sinking-fund method, it is probable that this is the most scientific. It does not necessarily follow that because the sinking-fund method of ascertaining the amount is used a sinking fund must actually be set aside in so many dollars and cents, or equivalent assets. It is based, of course, primarily on the theory which the sinking-fund calculation raises, namely: the sum which must be set aside annually, at compound interest, in order to equal at maturity the desired amount. Such would be the case with regard to depreciation if it were desired to replace physically the asset depreciated. It is not necessary, however, that this be done. The question to be determined is what amount shall be annually charged to operating expenses. The answer to the question is, therefore, such an amount as would annually, at compound interest, amount to the value of the asset to be written off. The marked objection to the sinkingfund method is that each time there is an addition to or deduction from the original cost of the asset the sinking-fund calculation is destroyed, and it becomes necessary to revise it. The following tables, charts and calculations show the relative advantages and disadvantages of the three methods above described, as well as others mentioned:

In connection with the methods just previously mentioned it will be noted that any addition to or reduction from the original asset will disturb the calculation seriously, except in the case of the flat rate. Addition to a given asset will have no effect upon the rate if the addition is of the same life as the original asset . Naturally, a deduction from the original asset will have no effect upon the rate. It will thus be seen that the life plays a very important part in the calculation of depreciation. If all property were of the same life, additions and deductions would have no effect upon the rate. The amount would, of course, change. For example: A given asset, costing $600, without residual value, might have an estimated life of ten years. In consequence, $60 would be the amount of the annual depreciation. If at the end of the second year a portion of the asset, corresponding to one-third, for example, were to be sold, the asset would be reduced to the extent of $200, and while the amount of the annual depreciation would be decreased to $40 the rate would not change. It would still be 10 per cent. on the remainder of $400. The converse of this proposition might be illustrated by a case wherein the original cost of the asset is $600, with the annual depreciation charge of $60. Again, if at the end of the second year additions to the extent of $75 are applied, the annual charge will be $67.50 instead of $60, corresponding to 10 per cent. of the cost of the asset, namely, $675. Attention should be drawn to the fact that in neither of these cases will it make any difference whether the addition or deduction takes place at the end of the second or some subsequent year. The vital point is that the additions and deductions must correspond in life to the original asset. For this reason it becomes almost impossible to compute depreciation from the asset accounts in the general ledger. Where attention is given to depreciation, and an attempt is made to compute it systematically, the details of the general ledger property accounts will, almost invariably, be found in underlying ledgers or memorandum books. Unless the assets are classified with regard to their respective estimated lives, when the calculation consists merely in taking the total cost less the estimated residual value in each class, and applying the rate determined by the estimated life, there will at once arise the question as to when the life begins and whether or not the beginning should correspond accurately with the date of acquisition of the asset. For example: In the case of a piece of machinery, purchased on the twentieth of November, in a given year. Shall the life begin on the twentieth of November, or shall it, for purposes of convenience in the calculation of depreciation, be considered as of the first of the following January? To repeat the question in general terms, shall additions to property during a given year be taken up, for purposes of depreciation, from the actual dates of acquisition or from the end of the year in which they were acquired? Generally speaking, it is proper to wait until the end of the year before putting additions to property on a depreciation basis. While this will probably be found to be the general practice, there will undoubtedly be exceptions to the rule in special cases where certain assets depreciate rapidly. In the case of concerns closing their books oftener than once a year it is usually customary to begin the depreciation as at the end of the period in which the property, or additions thereto, were acquired.

As to the manner of treating depreciation in accounts, there are two ways. One is to write down the asset to profit and loss; the other is to make provision for depreciation through a charge to profit and loss and the creation of a reserve. In the first case, granting that a certain machine cost $10,000, that the estimated residual value is $500, and the estimated life ten years, the journal entry at the end of the first year would be as follows:

Profit and loss or (depreciation) , $950.00
To Machinery $950.00

The second method spfTM*tn havp distinct advantages over the first method, in that it permits the asset to stand at its original cost, plus additions or dedurtiqnj^whik jts val11p is offset by a reserve, whereas In the first case the balance in the^acconnt results froma senei~ of transactions representing original cost. ndditir-ns, d^jiKtions Pph amounts writtpn off. It is, therefore,
preciation)

To Reserve for depreciation I difficult to determine, except through analysis, whether the credits ^ in the account are for sales, losses, or damage to the assets, or (amounts written off for deprpciat-ien. This would, perhaps, make little difference if all the details of an asset account were carried forward from year to year, but where new books are opened yearly the original cost of the asset is soon lost track of. This point might be an important matter in the case of a prospective sale, and while, of course, the original cost could be determined by an analysis of the old accounts, it would seem to be very much easier, and more satisfactory, to carry the asset forward from year to year at its original cost, plus actual additions and minus actual deductions, so that the cost would always appear in the current books; whereas the book value, being the difference between the cost and the reserve, could also be easily determined.
It also happens, in certain cases, th,af a concern will rlpsitf to put aside a fund_out of which to replace the assets at the end oftheir respective lives,. Where a provision for depreciation, has been made_thrn,,g*1 rnpfi;”m “f a reserve this is known as funding the reserve. The idea back of this scheme is that a fund will be accumulated from time to time which will be_sufficient, at the expiration of the life of the asset, to replace it. The fund may, of course, be accumulated without the creation of a reserve, but the effect at the expiration of the life of the asset is precisely the same. In the one case, namely, where the asset has been written off over a period of years to profit and loss, it will, presumably, have disappeared at the end of its estimated life. There will then stand in place of it the accumulated fund. In the other case the asset will remain; the reserve will have been created to an extent which equals the asset; the asset, at the end of its life, will be closed out to the reserve; and the fund will stand in place of the asset. The accumulation of a fund is, of course, conservative, and offers an opportunity for setting aside a small amount annually instead of being obliged to provide perhaps a large amount for replacement suddenly. The objection found to accumulating a fund is that almost any prosperous concern can make more money through the use of the cash in the business than a fund would return in the way of intergsL. It would, therefore, be found that in a prosperous concern, which might reasonably expect to have on hand sufficient funds for replacement at any given time, the accumulation of a fund would be unnecessary. So long as the annual profits are reduced by a provision for depreciation it would appear that the matter had been conservatively handled.

Many text-books discuss the creation of a reserve for depreciation, but very few have anything to say concerning its disposition. In the case above cited, where the cost of machinery was $10,000, the residual value estimated at $500, and the estimated life was ten years, it will be recalled that the annual charge for depreciation was $950. If depreciation were to be provided for through the medium of a reserve, at the expiration of the life of the machinery the reserve would show credits aggregating $9,500. The difference between the cost and the reserve would be $500. Two things might at this time happen, namely: the machinery continue in use, or be sold as second-hand or scrap. Although practically written off, its usefulness, while impaired, might warrant its continuance in use, and for all practical purposes it might apparently be worth as much to the concern as it ever was. The accounts might be allowed to stand as” stated, giving to the asset a nominal value of $500. If its earning power were still as great as before, the value is obviously greaterj than $500. Such a case has sometimes been given as an example of a secret reserve. This would, of course, be true whether or not the accounts were allowed to stand or whether the reserve was closed out to the asset and the book value thereof shown as $500.

Assuming the latter steps to have taken place, and the machinery to have been sold, then one of two things may result . First, the asset may have been sold for more than $500; and second, for less than $500. Assuming the sale to have brought $800, the transaction, expressed in the form of journal entry, would then appear as follows:
Cash or (accounts receivable) $800.00
To Machinery $500.00
Profit and loss 300.00
If, perchance, the asset realized only $400, the entry would be as follows:
Cash $400.00
Profit and loss 100.00
To Machinery $500.00

In case the original asset has been allowed to stand and a reserve created, the closing entry, that is, the one required to bring the asset down to its residual value, would be as follows:
Reserve for depreciation of machinery.. $9,500.
To Machinery $9,500.

The balance in the account would then be $500. As such it might remain or be treated as suggested in the preceding entries recording the disposition.

It should be borne in mind in connection with depreciation, and as a parting thought, that it is, at best, an estimate; that it rarely works out as planned, and that taking it into consideration is only an attempt to (a) properly state the estimated value of an asset and (b) provide for proper charges to operations.
It might also be mentioned, of course, that incidentally information concerning depreciation may be of value in securing accurate cost data and determining the relative efficacy of different types of construction or equipment. The fact is not to be ignored, either, that the federal corporation tax law requires all corporations to include depreciation as an item of expense.