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MICHIGAN.

Curtis, P. S. Gies, Fred * Ruple, H.

Thompson, Geo. E. * Webster, Norman E. Wixson, Fred

Total, 6.

MINNESOTA.

Freeman, H. J. .

Total, 1.

THE JOURNAL OF ACCOUNTANCY

Ohjo.
.Detroit

Bierman, V. D.
.Detroit
.Detroit

Collier, W. D.
.Detroit

Gano, C. A...
.Washington, D. C.

Leister, B. P.
.Detroit Lindars, F. W.

Loomis, N. H.
Pettis, N. F.

Rice, L. G.
St. Paul

Stuart, H. C.
Stallman, J. N.

Shaffer, F. T.
St. Louis

Throssell, Fred W.
St. Louis

Townsend, L. W.
.St. Louis

Vance, J. L., Jr.
. St. Louis

Wallace, M. J.
Minneapolis, Minn. Wirth, Herman
Minneapolis, Minn. Young, F. K.

Columbus Binghamton, N. Y.

.Cincinnati

Zanesville .Cincinnati Columbus Cincinnati

Cincinnati
New York City

Columbus
Columbus
.Cleveland
. Cleveland
Columbus
.Columbus
. Columbus
..Columbus

MISSOURI.

Ambrose, J. G.
Henry, Frank R.
Hurlbatt, E.
Houston, A. M.
Steele, J. Gordon
Walton, T. F.

Total, 6.

Total, 17.

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The Journal of Accountancy

Published Monthly under the auspices of the
American Association of Public Accountants

Vol. 3

DECEMBER, 1906

No. 2

Depreciation.

By Max TEICHMANN, C. P. A. Depreciation may properly be considered a branch of accounting science which, as yet, is not sufficiently appreciated. To treat all of its many features, phases, etc., would require the writing of a large volume, and then it would be found that not every question or point had been adequately and exhaustively covered. It often presents difficult problems in its proper treatment, and is subject to differing conditions, so that no hard and fast rules can be applied.

Depreciation is an impairment of the value of an asset by reason of wear and tear, accident, time, or similar causes. Furthermore, competition and improvement force frequent changes in plant value, which includes all machines, tools and appliances used in factory production, because if the general plant effectiveness of a certain factory is exceeded by that of any other factory engaged in the same line of production a condition of inferiority is established which, if not removed by improvement of plant, leads to losses and certain extinction. This assurance of future improvement, considering the present era of mechanical changes, necessitates an adequate depreciation percentage, if the present value is to be correctly represented.

Objections are sometimes raised to writing off or reserving for depreciation. There are those who desire to make as good a showing—so far as profits and dividends are concerned—as possible, but fail to consider the injustice they do to succeeding directors and stockholders. Others claim that because repairs and maintenance have been charged to revenue, the value and effectiveness of the assets are the same now as they were at the beginning. They forget that, no matter how much has been spent for repairs, the time will surely come when the entire assets will have to be replaced, necessitating a capital expenditure and the burdening of profits made during that year with the entire loss. The serious consequences which often follow could easily have been avoided, if depreciation over the entire period of the usefulness of the assets had been properly taken care of. Still others claim that no depreciation need be considered, because the cost of similar assets has increased, and some particular asset in use is actually more valuable now than appears as purchase price on the books. In this case it must be stated that where an asset has been purchased for the purpose of producing an income, and not for the purpose of a re-sale, it comes clearly under the head of "fixed assets,” and no fluctuations can have any bearing on its book value.

In the street railway field it is often claimed that no depreciation need be allowed on the fixed plant and rolling stock because, firstly, the amount involved is so large that mere repairs and renewals will average themselves; secondly, the natural growth of population will increase the earning power of the plants sufficiently to offset any deterioration in their physical condition, which can be made good by the issue of stocks or bonds. The fallacy of these contentions is clearly visible and hardly needs any further elucidation. It is obvious that proceedings of this kind must bring any legitimate enterprise down from a proper scientific accounting basis to a hazardous, speculative basis.

Sometimes revaluations are desirable to test the sufficiency of estimated provisions for depreciation, but it must be borne in mind that a revaluation can hardly fail to take into consideration fluctuation as well as depreciation, and, consequently, will affect the real result of profit and loss.

The best plan is to take the actual cost of, say, a machine, ascertain its probable life or usefulness less the break-up value (if any), and spread the cost over that ascertained period. This forms an equalized charge every year, which should be considered a working expense. Where items of different longevity or usefulness are carried on one account it is well to go into details at first, and to establish the average rate for depreciation on that account. Every year thereafter additions ought to be taken into account and a new average rate established. It is better, however, to have the account properly subdivided, i. e., more accounts opened, in order to keep the several classes of assets of this kind separate.

There are four methods adapted to providing for depreciation, as follows:

1. By a fixed proportion of original value. 2. By a fixed percentage of reduced balances. 3. By an annuity system.

4. By a sinking fund. (1) The fixed proportion method distributes the depreciation by equal installments over the period. (2) The fixed percentage method throws the greater part of the depreciation on the first few years. (3) By the annuity system the gross charge in respect of depreciation is constant, but the credits to revenue, in the shape of interest, diminish from year to year as the value of the asset decreases. (4) The sinking fund method is, perhaps, the most scientifically correct.

The first method is very generally used and can be applied to most concerns. The second method, throwing the greater part of cost to the first few years when the efficiency of the asset is greatest, works to a distinct advantage in a number of cases and ways, especially where machinery is subject to sudden mechanical improvements, thereby necessitating replacements in order to keep up the plant effectiveness. The third method has its advantages, but is rarely used in this country. The fourth method is not extensively applied by manufacturing and similar concerns for a number of reasons, one of which is that the capital invested in their own business earns a far larger amount of interest than can be secured by the outside investment of a sinking fund. Besides, if depreciation is kept in the shape of a reserve account, the amount of which may be invested in outside securities, this answers practically the same purpose. Revaluation may be considered a fifth method of allowing for depreciation, but, for the reasons already given, it is not advisable to encourage its use.

The following illustration will show the result of the four methods of depreciating, assuming that, (a) Machine has been bought and set up at a total cost of $1,000; (b) Its estimated life is twelve years; (c) The break-up value, or residual value, is $100; (d) The net cost, $900, is to be apportioned.

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$900.00 $900.00 $900.00 $900.00 The figures are to be obtained as follows:

Method 1.—Ninety per cent. of cost spread over twelve years equals 77/2 per cent. per year.

Method 2.—The fixed percentage on reduced balances is 1772 per cent, in this case.

Method 3.—The interest, 6 per cent., is charged to the asset, and a constant, equal sum-sufficient to reduce the asset to zero or its residual value—is written off each year. The net result is the charging off of an increasing sum to revenue, and its justification is that the depreciation installments remain in the business and thereby increase the working capital of the undertaking.

Method 4.—The sinking fund method hardly needs any further explanation, except that in this case the compound interest has been figured at 6 per cent.

Any of these methods may be employed, and, in case of the first two, instead of crediting the asset with depreciation direct, thereby reducing the amount on that particular account, it has been found advisable to leave it intact during the whole life of the asset by having a depreciation reserve account. In this case this reserve account is to be credited and revenue debited with the amount of depreciation. This reserve stands as a liability against those assets depreciated, but left intact on the books, and may either be used in the business or invested in outside securities. In the latter event this reserve would serve the purpose of a sinking fund, with the additional advantage that no fluctuation of interest in the future will affect it, because interest has not been considered at first, and the earnings on such outside investments are taken into revenue direct.

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