Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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properly belonging to a period subsequent to the date of
the Balance Sheet. In this class are found such items as
" Discount and Commission on Bonds," " Deferred
Charges to Operation," " Cost of Stripping Surface of
Mines," " Interest paid in advance " and many others.

Attention has been called to the discussion as to whether
certain expenditures, especially those made at the begin-
ning of a company's operations, should be considered as
mere expenses or as part of the cost of the plant to be
charged to Construction account. The items appearing in
Deferred Assets hold to some extent an intermediate posi-
tion, for they are not- conceived of as representing part of
the cost of permanent assets, nor are they charged at once
to the expenses of the year. Being clearly expenses they
are yet expenses which are offsets of future earnings, not
of past receipts. While in many cases not representing
any actual asset, they are correctly treated as though they
were assets. This may be clearly illustrated by an item
representing ' ' Interest paid in advance. ' ' This may be
an irrecoverable expense. It may not even be a reduction
of the amount of debts, for in many cases a prepayment
of a debt does not bring with it a discount for the time
before maturity. But to the going concern it is immaterial


whether the interest is paid in advance, or not being paid
there is in the treasury cash sufficient to pay the interest
when it matures. Thus the item " Interest paid in ad-
vance " is practically the same, so far as meeting the
interest expenses of the next fiscal period, as an equivalent
amount of cash. The former, as well as the latter, may
therefore legitimately be treated as an asset. As such
accounts represent a prepayment or anticipation of an
expense, and provide for the proper adjustment of net
profits as between different fiscal periods they are some-
times called Anticipation accounts, or Adjustment ac-
counts. The latter term is, however, used somewhat
ambiguously, and, especially in England, signifies what is
also known as a Collective account, or, in recent American
nomenclature, a Controlling account.

In some cases, as where it represents interest prepaid
for a short period, the Deferred Asset must evidently be
treated as an expense of the next fiscal period. In other
cases the Deferred Asset represents the prepayment of an
expense which pertains to the operations of several years,
as, for instance, the cost of stripping the surface may
cover perhaps twenty years of mining operations. Here
evidently it is strictly necessary that the total amount
should be charged off within the period to which it applies.
In some cases the Deferred Assets really represent pay-
ments covering permanent advantages, as where Organ-
ization Expenses are included under this general head.
Here it is not strictly necessary that the charge should be
written off but it may be carried indefinitely, just as it
might legitimately have been added to the value of the

But conservative companies are apt to charge these
items off more rapidly than strict necessity demands. Thus
one company charges off annually one-sixth of the " Dis-
count on Bonds ' ' although the bonds run for twenty years.


In another case one-eighth of a similar discount on bonds
was written off in the first year, but in the following year
the entire remainder disappeared.

At times there appear among the assets items which
represent not anticipated expenses but unusual losses
which the corporation does not see fit to charge at once
to Profit and Loss, nor to make manifest in a reduction of
capital. In such cases the charges which are deferred are
not the costs of future earnings, but losses which it is
expected future profits will cover. A striking instance of
such an item is found in the Balance Sheet of the United
Railways Investment Company for December 31, 1906,
where there appears " Earthquake, Fire, and Strike,
$859,983." Openly to show such an item is a vast im-
provement over carrying it concealed among the charges
to plant and other material assets. Of course, it is in no
sense an asset, properly speaking not even a Deferred
Asset. But by treating it as shown above the loss does not
necessarily interfere with current profits. The legitimacy
of so doing is discussed at length in Chapter XII.


DAWSON, S. S. Goodwill. Article in Encyclopaedia of Accounting,

III, p. 196.
DICKSEE, L. R. Goodwill and Its Treatment in Accounts. Third

edition. London, 1906. [The most complete treatment of

the subject.]

GUTHRIE, E. Goodwill. Accountant, XXIV, p. 425.
MORE, F. Goodwill. Ibid., XVII, p. 282.



DESTRUCTION is the law of nature. Fixed capital,
using the term here in its economic rather than in its
accounting sense, despite its name, is not exempt from this
law. Even so-called permanent improvements, such as
buildings, are all subject to the ravages of time, which
Marshall aptly defines as " the complex of destructive
agencies." All machinery is on an irresistible march to
the junk heap, and its progress, while it may be delayed,
cannot be prevented by repairs.

This obvious economic fact is of momentous import to
accounting, although full recognition has not been given
to it in general practice. It is one phase of the question
of the inventory discussed in the preceding chapters. It
implies that, in valuing all fixed assets, account must be
taken of the lapse of time, and even in the case of ma-
chinery giving no evidence either of use or misuse, the
bare fact that it is a year nearer its inevitable goal is an
item of which technical account must be taken.

In estimating the cost of production there must be con-
sidered not merely wages and material, interest and rent,
repairs and renewals, but in addition some allowance must
be made for the diminished value of the fixed assets due
to gradual loss of serviceability. Consequently profits are
not determined until after allowance has been made for
depreciation. Depreciation is not a' disposition of part of
the profits, but an expense without which profits can never
be learned. The principle is clear. Materials consumed



in manufacturing a commodity, as for instance fuel or oil,
are, of course, an element of expense. This is so because
an item of wealth disappears and its effect can only be to
diminish pro tanto the expression indicating the net wealth.
Its loss is in other words an expense. In the case of fuel
the loss is immediate, and is, therefore, charged at once to
expense. Exactly similar is it with the productive instru-
ments whose use extends over a longer period. The article
consumed in a single use must be considered an expense
of the current production, the temporary structure or the
tools lasting only a year are a charge against the produc-
tion occurring during that year. The more permanent
form of assets serving for productive use during a period
of years should be spread as an expense during the period
of use, whether that be five or fifty years.

If, instead of considering the year as the fiscal unit
of time, the entire economic period of production is re-
garded as the unit, the purchase of a machine, or the pur-
chase of a patent right are both expenses expenses to
the full amount of the cost. If a manufacturer, renting
his plant, produces a thousand engines in a year, it is clear
that the annual rental is a part of the expense of producing
the thousand engines. But, if the fiscal period is extended,
it is equally correct to say that the production of ten thou-
sand engines includes the total payment of rent for ten
years. Exactly similar is it with machinery and patent
rights. Assuming the life of each to be ten years, the
expense of producing ten thousand engines includes not
only rental for ten years, but as well the total cost of the
machinery used and the cost of the patent rights. A purely
artificial division of the productive process into fiscal years
is made. It is, therefore, necessary to make an artificial
and at best merely approximate division of these total
expenses into the shares to be allotted to the operations of
the several years.


"Where rent, interest, or other time payments are made
in advance, it ig customary, when any such sum is outstand-
ing at the time the annual balance is taken, to show the
prepaid rent, interest, or insurance as an asset. Thus on
December 1 a company may have paid $300 being six
months' interest in advance on $10,000, $1,500 as a quar-
ter's rental in advance and $1,200 one year's insurance.
A Balance Sheet made December 31 would show among
the assets : Interest prepaid $250 ; Rent in advance $1,000,
Unexpired insurance $1,100, making the apportionment, as
is customary in the case of short time items, proportionate
to the time elapsed. Such items are sometimes called
" Anticipation " or " Adjustment " accounts and are in-
cluded among the Deferred Assets. But logically the line
of demarcation from depreciation is extremely vague.
Considering the entire productive process, the total cost of
machinery and patent rights, is, as already stated, simply
an expense of production. But at the end of each year
part of this expense is conceived as pertaining to future,
not to past operations, and therefore a portion of the cost
of these so-called permanent, but really temporary assets,
is treated just as prepaid rent, interest, and insurance.
In other words, the asset item representing the value of
the destructible or otherwise terminable instruments of
production is logically similar to any of the Anticipation
or Adjustment accounts which also appear among the

The immediate effect of allowing for depreciation is
properly to equalize profits during different years. Other-
wise the total cost of the machine must appear as an ex-
pense of the year when it finally proves unserviceable. At
that time, its value ceasing, it can no longer appear in the
inventory. The amount of Goods on hand being thus
diminished, there must needs be a subtraction from the
Profit and Loss, or other Proprietorship account. But if


the original value of the discarded machine, say $20,000,
was continued on the books throughout its entire life of
20 years it may roughly be said that the proprietors in the
last year showed an excessive loss of $19,000, while the
proprietors during the preceding 19 years overestimated
their profits by the same amount. Such a procedure is
improvident where there is no change in proprietors or
stockholders; it is inequitable where the personnel has
changed; in all cases it is dangerous to the creditors who,
up to the last year, have not been shown the true condi-
tion of the company's assets.

The early writers on accounting made no allowance for
depreciation, and the advance that has been made in ac-
counting theory is still somewhat ahead of legal practice.
This is particularly true in the United States. Germany,
France, Belgium, Switzerland, Austria all prescribe in
their statutes that depreciation must be reckoned before
showing profits. In England, as in the United States, there
is no such regulation of accounting practice as is found on
the Continent, but the decisions of the English courts are
perhaps more satisfactory and consistent than those of this

At least so far as material wear and tear is concerned
the early case of Davison v. Gillies (16 Ch. Div. 347 n
(1879)) and the later one of Bond v. Barrow Haematite
Steel Co., Lim. ([1902] 1 Ch. 353) give clear expression
to the doctrine that depreciation must be reckoned. Less
satisfactory is the position of the American courts. In
the interesting case of Mackintosh v. Flint & Pere Mar-
quette Railroad Company, the court disallowed certain
items charged against operating expenses for depreciation
of steamers and dining halls, saying: " No expenditure
having actually been made to meet such depreciation the
estimated amount thereof could not properly be deducted
from earnings or net income/' (34 Fed. Rep. 609.)


Unfortunately the appeal of this case was never brought
to trial as a settlement was made between the litigants out-
side of court. But, in the earlier case of United States v.
Kansas Pacific Railway Company, the Supreme Court of
the United States held in regard to a charge for deprecia-
tion : ' ' We are clearly of the opinion that it is not a proper
charge. Only such expenditures as are actually made can
with any propriety be claimed as a deduction from earn-
ings." (99 U. S. 459.)

In the State courts there is a variety of decisions. One
of the most satisfactory is a New Jersey case (Whittaker v.
Amwell Nat. Bank. 52 N. J. Eq. 400 (1894)) where the
court held that in addition to the cost of repairs there must
be " a reasonable allowance for depreciation for wear and
tear or constant use. ... It cannot be successfully con-
tended that all such machinery is not subject to deprecia-
tion." In Michigan, too, the propriety of allowing for
depreciation seems to be recognized in the case of Richard-
son v. Buhl (77 Mich. 632) and it is most clearly allowed
in the Superior Court of New York City in Conville v.
Shook (24 N. Y. Supp. 547 (1893)).

But on the other hand it has been held in Georgia and
California that Depreciation need not be allowed. The
decisions in the latter State are particularly interesting
and refer to the depreciation of the plants of water com-
panies. To charge such depreciation against income was
said by one of the judges to be " all wrong " and " not to
be tolerated for a moment. ' ' J

A recent most important advance in the legal recogni-
tion of depreciation is found in the rules for preparing
railroad accounts promulgated by the Interstate Commerce
Commission. Here for the first time it is definitely pre-

1 See Tutt v. Land, 50 Geo. 339 (1873); Emery v. Wilson, 79 N. Y.
78 (1879); San Diego Water Co. v. San Diego, 118 Cal 556 (1897);
Redlands Water Co. v. Redlands, 121 Cal. 312 (1898).



scribed that a regular allowance, estimated monthly, must
be made for depreciation of seven named classes of equip-
ment. This ruling will doubtless have considerable effect
in giving recognition to the correctness of the principle
that depreciation is an unavoidable expense.

Two methods are used for booking depreciation. For
instance in a company whose Balance Sheet, before taking
account of depreciation is:


FORM 37.
Balance Sheet.


Plant $100,000

Cash 10,000


Capital $100,000

Profit and Loss 10,000


an allowance of $2,500 for depreciation can be shown
either by crediting that amount to the Plant account, re-
ducing it to $97,500 or by crediting it to a separate account
called Depreciation Account, or some similar title, in either
case the corresponding debit being to Profit and Loss. In
the latter case the Balance Sheet should be in the form
below :


FORM 38.
Balance Sheet.


Plant at cost $100,000

Less deprecia-
tion 2,500

- $97,500
Cash 10,000



Profit and Loss.



It is much more satisfactory thus to exhibit the original
cost of the plant and not merely to show the present depre-


elated value. Two companies might each show a plant
valued at $50,000. It is not a matter of indifference that
in one case this represents the total original cost of the
plant, while in the other it gives the residual value of what
was once worth $100,000. It has often been claimed that
to credit the depreciation to a separate account, instead of
to the account showing the asset, may lead to deception.
This is rendered more likely because the terms used to in-
dicate depreciation are frequently ill defined, and there
is danger that a mere recognition of depreciation may be
misunderstood as indicating a reserve of profits. Indeed
this fear of deception is so strong that German law, at
least according to the interpretation of Rehm, makes it
illegal to book depreciation by crediting a separate account
and requires that it be shown by writing down the value
of the asset. But any danger from this score is fully obvi-
ated by showing the credit to " Depreciation Account,"
not on the credit side of the Balance Sheet, but as a sub-
traction in an inner column of the debit side, as indicated
above. Some writers furthermore claim that by carefully
using the title Depreciation Account, and not the com-
monly used term Depreciation Fund, all confusion between
depreciation and a reserve fund proper will be obviated.
The Interstate Commerce Commission directs that the
credit be made to accounts entitled "Accrued Depreciation
Road," "Accrued Depreciation Equipment," "Accrued
Depreciation Miscellaneous Physical Property, " a separate
account being thus established for each class of depreciating

Admitting the necessity of allowing for depreciation,
the question arises as to the basis on which it is to be
estimated. It is not possible to determine by inspection
the present value of a machine or plant. Appraisers may
make the attempt, but in doing so one element which they
consider is the age of the machine and the depreciation


which time itself has wrought in its value. Some basis
must be adopted which, even if not strictly accurate, can
be conveniently applied. So far as depreciation by wear
and tear is concerned three factors are to be considered:
original cost, tenure of use, and residual value. The last-
named is of importance, for a machine is often displaced
before it becomes entirely worthless. Its residual value as
junk is exceeded by its value as a second-hand machine,
for the progressive establishment often discards machinery
still capable of considerable use.

"With these factors it is clear that the problem is how
to divide the difference between the initial value and the
residual value among the years intervening between the
purchase and the discarding of the asset. Various systems
are in actual use, among which the most prominent are
given below.

The simplest method is to divide the total depreciation
by the number of years' use, and charge the quotient as
annual depreciation, or in other words to charge each year
a fixed per cent, of the original cost. Thus a machine cost-
ing $600, expected to last five years, at which time it will
have a residual value of $100, should each year have a
charge of $100 or 16| per cent, of its cost to depreciation.
Expressed algebraically,


D= Vl Vz

in which D represents the amount of annual depreciation,
V 1 equals the cost price, V 2 the residual value, and n the
number of years.

The advantage of this method is the extreme simplicity
and the ease with which it can be estimated. For short-
lived assets it is doubtless to be preferred. Objection is
sometimes made that it requires constant reference to the
original cost price. If depreciation is directly subtracted


from the book value of the asset by crediting the amount
to the ledger account in which the asset appears, this defect
is of some significance, necessitating repeated reference to
a value no longer exhibited by the accounts. But where
a separate depreciation account is established and the
original cost remains an integral part of the accounts, the
criticism fails.

A second method is to charge a fixed percentage of the
decreasing net value. This gives not a constant, but a
diminishing annual charge for depreciation. In the in-
stance given above the depreciation instead of being 16
per cent, of the original cost, would be 30.12 per cent, of
the diminishing net value. The annual charges would,
therefore, be as follows:

FORM 39.


Value at beginning
of year.

Depreciation at
30.12% of diminishing


$600 00



419 28

126 28


293 00

88 25


204 75

61 67


143 08

43 09

Residual value. .

99 99

Expressed algebraically the formula is:

V, (1-r) (1-r) (1-r) (1-r) (1-r) = V 2

in which r represents the percentage of the diminishing
value to be annually deducted for depreciation, and V t
and V 2 represent, as before, the initial and the residual
value of the asset. Hence is derived as a working formula :

which is easily solved by the use of logarithmic tables. It
should be noted that this formula cannot strictly be ap-


plied where the asset has no residual value, that is where
V 2 0, as for instance, in a terminable leasehold, or an
expiring patent right. Practically it is applied even in
such cases by assuming a nominal sum, say one dollar,
or one cent, as the residual value. It will further be noted
that because of the elimination of fractions the balance
worked out generally will not exactly correspond with the
assumed residual value of the asset, but as, at best, depre-
ciation is a matter of estimate such small divergencies are
of no significance.

The advantage of this method, in addition to its easy
application to accounts showing the depreciated value of
the asset, is that it makes the charge for depreciation less
with each additional year. The argument in favor of this
course is that in the earlier years the charges for repairs
will be slight, but these will increase as the machine be-
comes older. As both repairs and depreciation are a
charge to expenses of production, the increasing repairs,
and the decreasing depreciation make a uniform charge to
expense, and thus profits are more equally apportioned be-
tween the several years during which the machinery is
used. Furthermore a declining depreciation is thought to
correspond better with the economic facts. The difference
in value between a new machine and one that is one year
old is probably much greater than the difference in value
of a machine which has been used 19 years and the same
machine a year later. Thus Tiffany estimates that machin-
ery in a flour mill depreciates 12^ per cent, of its cost the
first year, 8 in the second, 5 in the third, 2 in the fourth,
and only 2 per cent, each year thereafter. This decreasing
rate of depreciation is preserved by figuring depreciation
as a percentage of the diminishing value. The objections
to this method are obvious. It involves a complicated
mathematical calculation, and the annual rate of depre-
ciation gives little indication to the ordinary man of the



period required to write off the asset. Furthermore it
increases the depreciation charge in the earlier years, and
in the case of a new concern this may be distasteful as
being an additional charge against profits at a time when
business has not come into full swing and profits are low.
A third method, known as the Annuity Method, is even
more complicated. It rests upon the assumption" that the
cost of production includes not only repairs and the depre-
ciation of machinery, but as well interest on the amount
of capital invested in the machine. Depreciation on this
theory should be a sum figured as a constant annual charge
sufficient not only to write off the decline in value, but also
to write off annual interest charges on its diminishing
value. Assuming the rate of interest to be six per cent, the
reckoning should show:


FORM 40.
Machinery Account.


Cost price $600 .00

Interest at 6% 36.00


Balance $511.30

Interest 30.68


Balance $417.28

Interest 25.04


Balance $317.62

Interest 19.06


Balance $211.98

Interest 12.72

$224 . 70

Balance $100.00

Depreciation $124 . 70

Balance... . 511.30


Depreciation $124 . 70

Balance 417.28


Depreciation $124 . 70

Balance.. 317.62


Depreciation. . , $124 . 70

Balance 211.98


Depreciation $124 . 70

Balance 100.00



Algebraically the formula is derived as follows:
V x R-D ) R-D ) R-D ) R-D ) R-D = V 2

in which R equals 1 -f- (the rate of interest), or in this case
1.06 and D the annual charge for depreciation.


V 1 R 5 -D(R*+R 3 +R 2 +R-j-l)=r V 2

or in simpler form:

R 5 1

V T? 5 V

V i J.V Vo



R 5 1

D = V 1 W- V 2 -f-


or generally:

R n - 1

D = (VxR" - V 2 ) *

R - 1

These values are obtained easily by the use of logarithms,
or still more simply by the use of actuarial tables prepared

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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 10 of 27)