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followed in practice. Both the interstate commerce commission and the internal revenue bureau hold that depreciation shall be so computed, unless a satisfactory reason can be advanced for using some other basis. In the interstate commerce commission's classification of operating revenues and operating expenses of steam roads, effective July 1, 1914, special instructions, section 8, it is provided that the “depreciation charges shall be based in each instance upon the percentage of the original cost (estimated if not known), ledger value or purchase price of the property determined to be equitable by the carrier's experience and best sources of information as to the actual current loss from depreciation. A statement of the bases used by the carrier for computing these charges shall be included in its annual report to the commission." The original adoption of the interstate commerce commission's classification of accounts probably meant a considerable change in the methods of account-keeping for many of the railroads, so the commission naturally adopted at that time a policy of some latitude, yet clearly placing emphasis on the cost value of the assets. If the property was produced by the carrier itself, it was original cost, even though the lack of previous accounting made an estimate of that cost necessary. If the property was purchased, it was purchase price, which again may be called cost value to the purchaser. Even ledger value, if the accounts had been properly kept, would mean cost value, and if ledger value and cost value were not synonymous when these classifications went into effect, they will become more and more so, under the interstate commerce commission's supervision and regulation, as the years progress. The directions for the specific accounts provide that the depreciation charges "shall cease when the difference between the ledger value and the estimated scrap value shall have been credited to the accrued depreciation account." All this tends to prove our thesis that the purpose of the depreciation charge is to maintain the investment, and not necessarily to maintain the physical property.

It is interesting to note, however, that since the interstate commerce commission's classification of accounts does not require depreciation reserves to be set up for fixed property, but permits the roads to charge to maintenance all expense incurred in maintaining it, these charges maintain (or replace, if necessary) the

physical property, instead of simply maintaining the capital investment. This is true, even though the interstate commerce commission definitely states that the loss from property chargeable as operating expense shall be the difference between the ledger value and the estimated scrap value of the property considered.

The internal revenue bureau has laid down the rule, even more strongly than has the interstate commerce commission, that depreciation must be computed on the cost value of the assets, and that when the difference between this cost value and the residual value of the plant has been charged off as depreciation expense, no further depreciation may be written off. Due to the fact that our income tax dates back only a few years and that it would obviously be unjust on the part of the government to penalize businesses for the poor accounting or lack of accounting methods before that time, the internal revenue bureau, not as a matter of principle, but as a matter of expediency, provides in regulations 45, Article 164, that "the capital sum to be replaced by depreciation allowances is the cost of the property in respect of which the allowance is made, except that in the case of property acquired by the taxpayer prior to March 1, 1913, the capital sum to be replaced is the fair market value of the property as of that date.” A moment's consideration will show that this is no compromise of principle, for, as soon as assets in use at March 1, 1913, are worn out, only the original cost of assets will be accepted as a basis for depreciation. The regulations clearly set forth that the purpose of the depreciation charge is to maintain the capital investment and not to replace the plant.

TREATMENT OF UNEXPECTED Loss From OBSOLESCENCE

A second problem of present interest concerns the unexpected loss arising from obsolescence. Shall this capital loss or this loss as yet unprovided for through the annual charge for depreciation (even though the provision for depreciation does supposedly include an amount necessary to cover obsolescence) be charged against the accumulated profits of previous years as reflected in the surplus, or shall the amount be charged into operations as a cost of the current or following periods?

Aside from such regulations as may come at once to mind, the problem is not without interest. The product of every manu

facturer has its selling price determined by competition or by the maximum return possible under the supply-and-demand schedules of a monopoly or by the addition of a fixed percentage to the cost. The latter is really governed by one of the two former factors or by a combination of them.

If the selling price of the commodity is determined by competition, it may be assumed that no more could have been received for the product, regardless of its cost. To state this another way, the return from sales could not have been any greater even if this additional depreciation or obsolescence had been included in the cost of the product sold. It is obvious, therefore, that the margin between selling price and cost was greater than it should have been and that the profits of previous periods were correspondingly over-stated. This being true, the unforeseen loss must be charged against the accumulated profits of these past years, thus bringing that figure to what it really should have been.

In the case of the maximum return possible under the supply-and-demand schedules of a monopoly, it may be assumed that the unit selling price could not have been increased and the same number of units of product sold. This additional loss has increased the cost per unit of commodity produced, and it is possible that, had this extra item of cost been known, a different selling price might have been fixed. However, by the economic law of monopoly prices,* the manufacturer would not recover from the customers any of the loss resulting from the unforeseen obsolescence. Again, therefore, the entire amount must be charged against the otherwise over-stated profits of those years during which the now obsolete machine has been in use.

In the case of cost-plus contracts it may appear at first thought that this loss unjustly cuts down the profits already recorded for these periods. If this additional obsolescence had been included in production costs, the business would not only have got back that amount, but also would have received the regular percentage of profit on that expense. This would assume, of course, that the business would have got all the contracts it did get or their equiv

• Professor Marshall, in his Principles of Economics, page 480, 14, in speaking of decreases or increases in the cost of production under monopoly conditions, says: "Whatever be the price charged and the amount of the commodity sold, the monopoly revenue will be increased or diminished, as the case may be, by this sum; and there. fore that selling price which afforded the maximum monopoly revenue before the change will afford it afterwards. The change therefore will not offer to the monopolist any inducement to alter his course of action."

alent at the higher cost to the customer, but this assumption is by no means certain. The profits may not in this case have been overstated, and the business may feel that this loss should be held in suspense and charged as an expense to future contracts. But this raises the question as to whether or not future customers should be charged for under-charges made to past customers. The answer seems obvious ; also, as has been pointed out, the total cost of an asset must be absorbed by the product turned out during its life and not by any product produced after it has been discarded. So, even in this case, for the two reasons just given, it becomes necessary to absorb this unforeseen loss from obsolescence through the accumulated profits of past periods—the total returns from any machine or group of machines necessarily absorbing the entire capital outlay on account of those assets.

It is interesting now to turn from the theory to actual practice regarding this type of loss. In the interstate commerce commission's classification on operating revenues and operating expenses of steam roads, effective July 1, 1914, under operating expense accounts special instructions, paragraph five, it is provided that "the ledger value (less salvage and the credit balance in the accrued depreciation account with respect to the property retired) of fixed improvements retired and replaced with property of like purpose, together with the cost of removing the property retired, shall be included in the accounts appropriate for the repairs of the property before retirement." This means that this unforeseen and unprovided-for loss shall be included in the expenses of operations for the year. Whether the amount is carried directly to the accumulated profits (profit and loss, in this classification), thus permitting the current year to show its normal profit, or the current year shows a correspondingly small profit and the accumulated profits remain unchanged, the same result is reached at the close of the period in which this unforeseen loss occurs. However, it does not seem just thus to burden the current year with the mis-estimated depreciation cost of former years.

These special instructions further provide that in case the amount chargeable as operating expenses for property retired and replaced is relatively large, and its inclusion would seriously distort the expense accounts for a single year, the carrier, if so authorized by the commission, may charge the amount thereof to balance-sheet account No. 726, "property abandoned chargeable to operating expenses," and distribute it

thereafter, in accordance with the provisions of that account to the operating
expenses of succeeding years.
Or,
if so authorized by the commission, the carrier may charge to profit and
loss any extraordinarily large item representing the cost of property retired
and replaced, instead of charging such item to operating expenses. The
carrier shall file with the commission a statement of the cost and a descrip-
tion of the property retired and the reasons which, in its judgment, indicate
the propriety of charging the cost of such property to profit and loss.

Inasmuch as under this classification of accounts no provision for depreciation need be made, unless desired, for fixed improvements, these large amounts representing the difference between ledger value and residual value, less the accumulated credit to the reserve for depreciation accounts, will often represent elements other than unforeseen loss from obsolescence. But, if so authorized by the commission, any or all of these charges may be charged against the accumulated profit and loss. Inasmuch as the assets have been in use over a period of years, unless the charge to operations on account of retirements and replacements of composite plant is fairly uniform from period to period, in which case the result is the same though the theory remains unchanged, the total cost therefor is chargeable to the entire period of the economic life of the assets. The gross loss, upon their retirement from service, should be chargeable against the accumulated and correspondingly over-stated profits of those same years.

As regards the regulations of the internal revenue bureau, article 143, regulations 45, provides that when through some change in business conditions the usefulness in the business of some or all of the capital assets is suddenly terminated, so that the taxpayer discontinues the business or discards such assets permanently from use in the business, he may claim as a loss for the year in which he takes such action the difference between the cost or the fair market value as of March 1, 1913, or any asset so discarded (less any depreciation allowances) and its salvage value remaining.

Special provisions then follow requiring full explanation as to why the assets were discarded, and additional provisions (articles 181-188, regulations 45) take care of special losses arising from amortization of assets used especially for war production. It may seem that all these legal provisions violate the accounting principles as above stated, but a little consideration leads one to conclude that whatever violations may exist result not from any desire to set aside the principles of good accounting, but from

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