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unit prices of various property units, or as specific charge
against some particular schedule or group of units;

(e) Administration, including salaries for general officers, agents >
accountants, clerks, and other assistants, not included in the
engineering and legal departments, and all administration
expenses ;

(/) Legal, including salaries and expenses of law officials and
costs of litigation which, depending on the character of the
property and its location, may be a comparatively minor item
or a very large one;

(g) Interest during the period of construction, on money borrowed,
or on money invested in the property by its OAvners ;

(h) Taxes and insurance during construction; and

(i) Contingencies, representing expenditures which cannot be
foreseen but which from one cause or another are always of
considerable size in the construction or reproduction cost esti-
mate of any great enterprise.

Depreciation and Appreciation.

With a desire to remove the ambiguity and resulting confusion
that has attended the use of the term "depreciation" in connection
with valuation, the Committee has considered the subject from three
standpoints: (1) the cause, decretion or loss of service life; (2) the
record, accounting depreciation, or the money allowance made in book-
keeping to offset accruing loss of service life; and (3) the amount
sought, depreciation of valuation or fair depreciation, the sum which
should be deducted from original cost to date or from estimated cost
of reproduction new as a step in finding that which the Courts have
called "fair value".

Decretion. — This is the fact of loss of service life of a physical
property, or property unit, or item, regardless of its effect on value
or anything else. It may be due to use, or inadequacy, or obsolescence
or accident, either singly or in combination in a given plant or
plant unit.

Although, in a well-maintained property, decretion is always pres-
ent in some degree, yet in some cases this decretion, converted into
loss of value, which loss is hereafter called cost of decretion, should
not be considered to be a deductible quantity in finding the value of
the property — that is, it should not be considered as depreciation of
valuation, or fair depreciation. Unfortunately, this has not been
entirely understood.

Whether or not, and to what extent, if any, the loss of value due to
existing decretion shall be deducted from original cost to date or cost



VALUATION OF PUBLIC UTILITIES 1335

of reproduction new, when finding "fair value" for any purpose, is the
great troublesome problem of depreciation in valuation.

Accounting Depreciation. — The fundamentals of the methods of
accounting for depreciation are that the owner of a public utility
is under obligation to the investors in its securities to maintain the
integrity of the investment as a continuing property and to furnish
suitable service to the public; that the public is xmder obligation to
the owner to pay a fair price for the service rendered, which should
cover all operating expenses, a proper allowance for depreciation and
a fair return upon the "fair value" of the property; and that the
return to the investor and the rates to the consumer should be kept
reasonably stable and uniform from year to year and should be fair.
The four accounting methods in use for accounting for deprecia-
tion, the replacement method, the straight-line method, the com-
pound-interest method (formerly called by the Committee the "equal-
annual-payment method"), and the sinhing-fund method, yield
identical total costs when the whole life of a property unit is
considered, and any one of them seeming to be the most convenient
may be chosen, provided only that under the circumstances it is legal,
safe, and fair.

The replacement method is applicable to those short-lived proper-
ties or parts of properties made up of a large number of items, the
replacement or retirement of which proceeds after a time with fair
regularity and causes no troublesome variations in return or service
rates; the straight-line method applies to any property units having
more than a year of service life, which are assumed to depreciate uni-
formly from the beginning to the end of service life; the compound-
interest and sinking-fund methods apply to property tmits the deprecia-
tion of which is assumed to progress at the same rate as a sinking fund
grows from an annuity, accumulating at compound interest.

In addition to these four methods there is the unit cost method,
eminently sound in theory but not readily applicable to accounting
purposes, which is based on the conception that the value of a
plant unit should be decreased from year to year to such an extent
that the cost per unit of output or service, taking into account all
annual charges for interest, depreciation, repairs, cost of operating,
etc., should be constant during each year of the estimated service
life of the unit.

The great discrepancy in the growth of depreciation of long-lived
units under the straight-line and compound-interest theories should
be carefully noted when determining which method to use.

This report is particularly concerned with depreciation accounting
as it relates to valuation, and the determination of the depreciation of
valuation. It would seem to be fair in any given case to give the
method of accounting used by the utility in setting up depreciation



132G VALUATION" OF PUBLIC UTILITIES

allowances its proper effect in determining deductible depreciation or
the depreciation of valuation.

Depreciation of Valuation Dependent on Accounting Methods and
Regulations. — Finding the cost of decretion, here defined as the loss
of service life of an item converted into loss of value, is a step in
the determination of depreciation, but whether and to what extent,
if at all, the estimate thus found shall be treated as depreciation of
valuation may be, and very probably will be, dependent, at least iu
part, on the methods of accounting for depreciation and the character
of regulation that have prevailed.

Depreciation of Valuation under Replacement Method. — If by order
or sanction of a regulating body, or by long-continued proper custom
under no regulation, a property, as for instance a railroad, has been
maintained in normal working condition, necessarily less than new in
some or all of its parts, by the replacement method, and at any given
date is being valued for any public purpose and at that date shows
normal condition, all its several parts being in as good condition as
could be expected, the accounts showing that those amounts have been
expended in renewals that were necessary to keep the property in
normal working condition, and the fact appearing that no expenditure
reasonably to be expected could put the property in better than the
normal condition in which it is found, and that no unusually large
expenditure is presently to be necessary for this purpose, then, in spite
of the fact that there is an existing decretion in its several parts,
there should be found no depreciation of valuation. Under the method
of accounting, the public has not paid, and could not pay, for the ac-
crued depreciation, and under this condition its accrued obligation to
pay should be considered an asset of the company owner.

If parts of the property are maintained under the replacement
method and part by some proper allowance method, then, except as
noted below, depreciation of valuation should be found with respect
to those parts maintained under the allowance method, but this de-
]")reciation of specific physical units will be made good in whole or
in part by existing funds or property purchased with allowances, either
or both of which will be included in the valuation as they are found.

If in the judgment of the valuing engineer, the replacement method
may not be used with propriety for a given property, either because
not in accordance with law, or because the method is not adapted to
the property, then, whether or not the property has been maintained
in the past under this method, the valuing engineer should estimate
depreciation of valuation in the amount of the cost of the decretion
he finds. There can be no certainty that the property will be properly
maintained in the future.

When a comparatively new property, other than a railroad, is to
be valued, and it has not been under any regulation that has affected



VALUATION OF PUBLIC UTILITIES 1337

its accounting methods, the law as laid down in the Knoxville decision
would seem to make it necessary to find depreciation of valuation in
amount equal to the cost of decretion found for all items, whether or
not maintained by the replacement method. The Committee, however,
believes that this may work hardship and injustice in some instances,
and suggests that in such cases the facts be reported with such recom-
mendations as to equity, as may seem fair to the engineer.

Depreciation of Valuation under Allowance Methods. — If either
the straight-line, compound-interest, or sinking-fund method has been
used in computing depreciation, and the method of accounting for it
has been prescribed by a regulating body or voluntarily followed by a
company owner from the beginning, the same theory, so far as it
applies to the property in question, should be used for estimating the
cost of decretion ; and the entire cost so found, lessened by any accumu-
lated depreciation fxmds, will appear as depreciation of valuation, unless
the sinking-fund method of accounting has been used. In the latter
case, if the valuation has to do with the reasonableness of the return
and the accounting is to go on as before, apparently existing deprecia-
tion would not be depreciation of valuation, and therefore would not be
deductible; but if the valuation has to do with condemnation or pur-
chase, then, as in other cases, the apparently existing depreciation is
depreciation of valuation, and the owner should receive the depreciated
value of the physical property and the existing fund.

Effect of Regulation on Depreciation of Valuation. — Regulation
which determines the method of accounting will in part determine the
amount of depreciation of valuation when finding "fair value", because
it determines the method by which the public shall pay for the loss of
service life. If the regulating body has prescribed the replacement
method for the whole period that units have been in existence, then,
although depreciation may exist, it is not depreciation of valuation,
because, under the method of accounting, the public has not paid, and
could not pay, for the accruing depreciation, and is still under obliga-
tion to pay for it.

Methods of accounting in force at the present time which make
proper provision for the accruing depreciation should not have full
weight, if, in previous years during the life of the property units, other
methods were in use which did not make provision for such deprecia-
tion. The amoimt of depreciation of valuation in such cases shoxild
be equivalent to the accumulated contributions of the public for depre-
ciation allowances vrnder the various methods of accounting which have
affected the property unit from time to time. The public is still under
obligation to make good that part of the loss of service life not yet
paid for, and this obligation should be considered to be as much the
property of the company usable to offset accrued depreciation as re-
newal frmds or property actually in existence.



1328 VALUATION OF PUBLIC UTILITIES

Whether or not this reasoning will stand in any case is for the
Court to determine. Valuing engineers and accountants should report
what they find as to the actual cost of decretion, and the sums which
have been received to offset such cost, under the methods prescribed by
the regulating body from time to time. They may give their opinions
as to the amount of depreciation that should be deducted from cost to
find cost less depreciation as an element in the quantity known as
''fair value".

If regulation has not fixed accounting methods, but has limited
the earnings, it should be permissible to inquire whether the limited
earnings have been sufficient to pay operating expense, depreciation,
and fair return. If so, depreciation found should be considered depre-
ciation of valuation to the extent warranted by the accounting methods
lawfully or properly followed; if not, a question arises. It is remem-
bered that the duty of the company owner is first to maintain the prop-
erty "before coming to the question of profit at all", and that it is
the duty of the regulating body to see that rates are such as to permit
the company owner to earn operating expense, depreciation, and fair
return. If the regiJating body has made sufficient earnings impossible,
is it still the duty of the company owner to maintain the property
before paying fair return to its security holders ? If it is, depreciation
of valuation should be found in the amount of the total cost of decre-
tion or so far as warranted by the accounting methods followed. If
not, depreciation found should not be considered depreciation of valua-
tion except to the extent covered by earnings after deducting operating
expense and fair return. This is a matter of equity to be determined
by a Court. If under regulation the property is a losing venture, it is
not included in the class of properties now being considered. In any
event the depreciation existing should be found and reported, together
with all pertinent facts, that the Court may determine the equities
of the case.

Conclusion upon Depreciation. — The valuing engineer should bear
in mind that when a company owner has invested a reasonable sum in
a property for public service, it is entitled to, but not guaranteed, a
fair return on its investment, so long as the money remains in the
property, either as property, or funds, or accrued public obligation to
pay. Therefore, so long as the company owner keeps a swoa. equivalent
to the total investment at work for the public, either as property serv-
ing the public, or funds held in reserve for such property, no policy
should be followed in estimating depreciation that will reduce the prop-
erty to a value less than the investment, or, when using cost of repro-
duction less depreciation, as a basis of "fair value", to a value less
than the cost of reproduction of that part of the property estimated to
have been created with company funds, acquired by gift, or in any way
not the result of public contributions to cover depreciation.



VALUATION OF PUBLIC UTILITIES 1339

Appreciation. — Appreciation, largely the result of solidification,
seasoning and adaptation, represents the improvement in quality and
usefulness of certain parts of the physical properties of a railroad or
other public utility property, and it results from the lapse of time,
from work not specifically charged to capital account, from main-
tenance, from use, etc., and covers items, not represented either by the
quantities or unit prices, that are determined in connection with a
valuation.

There should be no general setting off of appreciation against depre-
ciation, but appreciation should be determined independently from
depreciation. Care must be taken that items of labor and expense
included in the estimate may not be duplicated in development expense.

Development Expense.

In the production of a normal going property, development expense,
almost invariably, is an unavoidable real cost, and is measured by the
difference between the amount which the company is entitled to earn
in the early years and the amount which it actually does earn. The
portion of this expense incurred in tuning up the property and bring-
ing it to its present state of operating efficiency may be included in
the cost of construction, and the remainder may be treated as the cost
of acquiring the business.

Intangible Value.

The intangible value that pertains to a property and should be
given due weight in the ascertainment of "fair value" is the difference
between the tangible value — that is to say, proper cost including de-
velopment expense, less depreciation of valuation — and exchange value,
in which is reflecced existing and potential dependable income and
beneficial results. It embraces going value, in which is merged good
will, franchise value, efficiency, favorable business arrangements and
design; and it also includes other elements, such as leases, easements,
water rights, traffic and operating agreements, strategic location and
advantages, and other privileges.



1330 VALUATION OF PUBLIC UTILITIES



CHAPTER I.



INTRODUCTION.

The Special Comraittee of seven, appointed by the Board of Direc-
tion in September, 1911, to Formulate Principles and Methods for the
Valuation of Railroad Property and Other Public Utilities, presented
to the Board, early in December, 1913, a Progress Report on the sub-
ject of Valuation for the Purpose of Rate-Making.

One member of the Committee was unable to take any part in its
deliberations, and consequently did not wish his name attached to the
report, which was signed by all the remaining members, consisting of
Frederic P. Stearns, Chairman, Leonard Metcalf, Secretary, Thomas
H. Johnson, Alfred Noble, William G. Raymond, and Jonathan
P. Snow.

The report was presented at the Annual Meeting of the Society on
January 21st, 1914, and, after a brief discussion, the following resolu-
tions were adopted: First, a resolution offered by the Chairman, as
follows :

"Resolved, That the Progress Report of this Committee, together
with all discussion thereon up to September 1st, 1914, or to such later
date as the Board of Direction may fix, be referred back to the Com-
mittee for further consideration; and that in the meantime the Board
of Direction be requested to assign a date for the written and oral
discussion on the subject."

Second, a resolution offered by a member :

"That inasmuch as each member of the Society has a copy of that
report, that it be not published in the Proceedings until the final report
of the Committee is issued."

A special meeting for the discussion of the Progress Report of the
Committee was held on March 11th, 1914, when the report was discussed
by ten members of the Society, and the meeting was adjourned until
April 2d, 1914, when it was again discussed in the afternoon and
evening by fourteen members of the Society. The total number of
written discussions to the present time is sixty-three, covering 340
printed pages of the Proceedings.

The Committee suffered a great loss by the death of two of its
members: Thomas H. Johnson on April 16th, 1914, and Alfred Noble
on April 19th, 1914. To fill the vacancies thus created, and a further
vacancy caused by the wish of Henry M. Byllesby not to remain on
the Committee, the Board of Direction on May 6th, 1914, appointed
to the Committee Charles S. Churchill, William J. Wilgus, and Henry
E. Riggs.



VALUATION OF PUBLIC UTILITIES 1331

Several of those discussing the Progress Report contended that
the Committee, in making a report on Valuation for the Purpose of
Rate-Making, should have omitted railroads from its discussion, prin-
cipally on the ground that railroads are competitive, and that their
rates are to a large extent interdependent and must be fixed in accord-
ance with these conditions. Some have gone so far as to infer that
it was the aim of the Committee to suggest methods for determining
individual rates to be included in a tariff, although there was no sug-
gestion of this kind in the Progress Report, which dealt only with
returns as a whole; that is, with the aggregate sum to be earned by
means of the rates.

The Committee recognizes fully that an engineering valuation of
the property of a public utility is only an element in fixing rates, and
that this is especially so in the case of railroads and other competitive
public utilities. It agrees with the view as to railway rates, ex-
pressed by Judge Prouty in his address to the United States Chamber
of Commerce on February 11th, 1914, when he says:

"The rates of public utilities are at the present day usually fixed
by commissions, both state and federal. It is perhaps the natural
inference that when the value of the property has been determined and
the rate of return fixed the work of the commission in establishing the
charge of the public utility is comparatively easy. It is only neces-
sary to multiply the value by the rate and to allow a charge which will
yield that income.

"And this, with some important qualifications, is true as to certain
kinds of public utilities. Take, for instance, a water plant or a gas
plant. This serves a single community. As a rule it meets no com-
petition in that service. The amoimt of its business is known or
can be forecast with reasonable accuracy. Even matters of deprecia-
tion and such like have come to be pretty accurately understood. It
IS possible, therefore, to fix with some confidence the rates of such a
utility when the value of the investment is known.

"With the railroads, however, this is entirely different for the
reason that it seldom happens that a single railroad can be considered
by itself. The greater part of the business of the railways of the United
States is subject to competitive conditions of one sort and another
which are largely controlling so that the rates of one are necessarily
bound up with those of another. A moment's thought will show the
extent to which this is true."

Also:

"* * * the railroads of this country are so bound up together
that their rates are largely interdependent. It is impossible to shake
a single railroad free from every other and fix its charges upon the
basis of a fair return upon its fair value as you would in case of a gas
or water plant. The rate established for one, of necessity, influences
and frequently absolutely determines the rate of all, a fact which
must never be forgotten in discussing this subject."



1332 VALUATION OF PUBLIC UTILITIES

In the same speech, however, he adds:

"While, however, I wish to make it perfectly plain that the prob-
lem of establishing railway rates will not be solved by this valuation,
I desire to say with even greater emphasis that the problem will be
enormously simplified. It can be Icaown with certainty whether the
general level of rates is or is not too high, and in establishing the
charges to be observed by a single carrier, even in fijsing the rate upon
a single commodity, it will be of much benefit to know the value of
the property involved. Every railroad commissioner will join with me
in saying that here is the only solid fomidation upon which he can
stand; that the determination of these values is indispensable to the
just and intelligent administration of his work.

''While this valuation will be of incidental benefit to the investor,
while it is essential to the work of the rate-making tribunal, it seems
to me that its greatest immediate value is political. The state of the
public mind towards our railways is such that this information is
absolutely necessary."

Whether or not it is proper to base rates on the so-called "value"
of the property is no concern of the Committee. The fact is that in
many instances, including cases of railroad rates, the reasonableness
of rates has been so determined, and, in making their decisions in
disputed cases, the Courts have quite uniformly held that a public
utility corporation is entitled to earn a "fair return" on the "fair
value" of its property used in the jjublic service.

Whenever the determination of the reasonableness of rates is
reached in this way, it is necessary to value the property, and to value
it in such a way that justice shall be done to the corporation and to
the public. As this use of valuation of public utility properties was
and now is prominently in the public mind, it seemed desirable to
consider first the methods of valuation for this purpose. Hence, the
Progress Report was limited to this field.

There seemed to be a failure to understand completely what the
Committee proposed in its Progress Report, and there were those who
contended that there could be but one value for any plant operated
for gain, no matter what the purpose of the valuation. Further con-
sideration by the Committee leads it to believe that much, if not all,
of the misunderstanding is due to the unfortunate multiple meaning
of the word value. In its own discussion the Committee has had
difficulty in reaching conclusions, due to this cause. In its Progress
Report the Committee adopted the current usage of the v/ord value



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