Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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for the use of insurance companies; for evidently V^R n is
the accumulated value of F x at 6 per cent, compound in-
terest for n years, and the coefficient of D is the accumu-
lated value at 6 per cent, interest of an annuity of one
dollar paid at the end of each of n years. Such values
are given in ordinary actuarial tables.

The use of this system implies that at the time interest
is charged to the plant there is a corresponding credit
to interest acctrant. Consequently the net result to Profit
and Loss account taken as a whole is that there is an equal
annual charge of depreciation, and a diminishing annual
credit for interest.

An objection to the last-named method is that it intro-
duces the custom of marking up the value of assets by an
allowance for assumed interest. In this particular case



no inflation of profits results because there is an increased
charge against profits for depreciation. But it is ques-
tionable whether it is not so dangerous a practice as to
make objectionable anything which seems to justify it.
Furthermore, unless interest is charged on all capital in-
vested, not merely on that subject to depreciation, there is
a logical inconsistency in reckoning it in depreciation.
And finally, its value consists in separating the profits of
manufacturing, or other business operations, in which de-
preciating capital assets are used, from the profits derived
from the use of capital. This is so because the large depre-
ciation charge goes into the Trading account, 1 while the
countervailing credit to interest goes into the Profit and
Loss account proper.

The three methods of figuring depreciation have this
marked difference. The annual charge against profits de-
creases where depreciation is a fixed percentage of the
diminishing value of the asset. It is constant where depre-
ciation is a fixed percentage of the cost ; it increases where
the third method is used. A comparison of the amount
annually charged to depreciation under each of the meth-
ods described is shown by the following table.

FORM 41.

Depreciation of Asset Costing $600 with Estimated Residual Value at
End of Five Years, of $100.


16%% on

30. 12% on

Annuity system, 6 interest.

Gross Charge

Gross, less interest




124 . 70











1 See Chapter XV.


Authorities differ as to the desirability of one or other
of the three methods. Dicksee's high authority favors the
first for short-lived assets, the second for machinery in
general, the third for long-time terminable leaseholds and
similar assets. Where the courts prescribe depreciation
they have generally allowed the basis and, indeed, the
period to be left to the discretion of the company authori-
ties. Even in Germany where statute law is most precise,
demanding that depreciation be reckoned, and in cer-
tain cases even prescribing the period, there is no legal
preference given to one or other of the methods of cal-
culation. Practice, however, in England, Germany, and
the United States seems to favor, in general, the taking of
the diminishing value of the assets as the basis of calcula-
tion. But the Interstate Commerce Commission definitely
prescribes that when depreciation is reckoned there shall be
a uniform monthly charge, based on the percentage of the
original cost which, in accordance with the best sources of in-
formation, equitably represents the average current loss
from depreciation.

In discussing the relative merits of the differing sys-
tems of depreciation, it must be borne in mind that allow-
ance for depreciation is only part of a broader scheme
whose purpose is to equalize charges between different
years. It has been shown that the real cost of manufac-
turing includes both repairs and depreciation of plant.
The total amount paid on both these accounts is properly
a charge to the total cost of production during the period
that the plant lasts. But the accidental fact that actual
payments are not made uniformly is no reason why the
annual charge should vary. One does not consider the
semi-annual installment of rent or interest as an expense
peculiar to the month in which it is paid. Neither
should the fact, if it be one, that a machine declines in
value more in the first year than in the last year of its life


justify making a greater charge to costs in the former year.
The complete and scientifically correct method of figuring
depreciation compels that there should be at the same
time a recognition of the necessity of repairs and a simul-
taneous apportioning of both repairs and depreciation
between the years irrespective of the time when the ex-
pense is actually incurred. There should, therefore, be
two estimates made, one of the total shrinkage of value
during the life of the machine, the other of the total cost
of repairs during the same period. This being done there
should be an equal apportionment of the sum of these two
between the several years. In other words there should
be an equal annual charge to expense and a credit to De-
preciation account and to Renewal or Repairs Account.
Replacement of outworn machines or repairs made can
then be charged to these accounts. If the estimates are
made with approximate accuracy there will result a dis-
tribution of expense between the several fiscal periods.
But where no such uniform annual charge is made to
cover repairs, and where expense is annually charged with
the repairs actually made, sometimes more and sometimes
less, a more correct final showing will be secured by mak-
ing a sliding charge to depreciation, as is done where it is
based on a fixed percentage of the diminishing value.
This does not mean that the allocation of depreciation in
this manner is in itself more correct, but that this error
in apportionment offsets and neutralizes the increasing
charges for repairs. But this is at best a rather awkward
rule of thumb. The fuller, more scientific treatment of
both repairs and depreciation, as being properly a uniform
annual charge, is coming more into favor, and is implied
in the scheme of accounts promulgated by the Interstate
Commerce Commission.

Whatever uncertainty there may be as to the three meth-
ods of depreciation already described, there is no doubt a.s


to the illegitimacy of a fourth system that is not infrequent-
ly used. This is to make the amount annually written off
for depreciation somewhat loosely proportionate to profits.
The natural inference from this practice is that in the ab-
sence of profits no depreciation is to be reckoned; while
the fundamental principle involved is that depreciation is
something inexorable, inevitable, an expense to be esti-
mated before it is possible to determine profits. This view
is accepted not only by accountants but in Germany at
least has been given legal authority by judicial decisions.
The correct attitude has been taken in this country, too, by
the Interstate Commerce Commission which has adopted as
its rule the statement made by P. D. Leake: " One of the
most vital matters connected with productive industries
and trading concerns is the regular assessment with sub-
stantial accuracy of the annual net profit or loss which has
resulted from the operations of each year; and unless a
near approximation to the outlay on productive plant
which has expired within each year is made and fully pro-
vided for out of gross revenue, no correct statement of
profit or loss can be obtained. . . . No Profit can exist
until Expired Outlay on Productive Plant has been pro-
vided out of Gross Revenue." 1

Present practice is unfortunately not up to this correct
principle. Any recognition of depreciation at all being
relatively uncommon in the accounts of American corpora-
tions, it is not to be wondered at that the few companies
which show depreciation in prosperous years, when profits
are large, grow faint hearted when business is poor. A
few exceptions are to be noted, among which may be men-
tioned the Allis-Chalmers Company which in 1906 charged
nearly $300,000 to depreciation, although that resulted in
a total deficit of nearly $400,000.

1 Interstate Commerce Commission. Accounting Series, Circular
No. 13.


Depreciation should cover all decline in value due to
the use of productive assets. No less than this is required
by accounting prudence. But while this standard is fre-
quently not reached, it is not unusual to find corporations
charging to depreciation sums far in excess of the actual
decline in value. Yet such excessive depreciation offends
the very principles of accounting. To charge too much
to depreciation is no less a deviation from accuracy than
to charge too little. Yet the two transactions are very dif-
ferently regarded by the public and by the profession. To
charge too little is considered dishonorable, to charge more
than enough is considered a sign of conservatism and is
not only done by the most reputable corporations, but
where this occurs the action is very frequently praised by
financial writers.

The effect of excessive depreciation is to conceal the
amount of profits, to create what is known as a " Secret
Reserve." Depreciation is normally charged to expense,
or at least to Profit and Loss. If, in fact, there has been no
actual decline in value, the result is that the Balance Sheet
shows an understatement of both assets and profits. The
questions involved are, therefore, those of undervaluation
of Assets and Secret Reserves both of which are elsewhere
discussed. Here it suffices to call attention to the fact that
an excessive depreciation, while generally condoned, is still
a divergence from an ideal accounting, and its effect is the
establishment of a Secret Reserve.

The question is frequently raised as to whether depre-
ciation provides for the replacement of the wasting article.
The question itself, although sometimes propounded by
accountants, involves a misapprehension. Depreciation in
itself merely means that there has been a decline in the
value of certain assets. If this results in a net loss evi-
dently there is nothing with which to replace a destroyed
asset. For instance, a company with Plant $100,000, Capi-



tal $50,000, and Debt $50,000 suffers a depreciation of two
per cent. If other expenses just balance income, this means
a net loss of $2,000. The Balance Sheet then would read :


FORM 42.
Balance Sheet.


Plant $100,000

Less depreci-
ation 2,000

Loss 2,000





The plant is the only possession of the company, and
there are no other free assets with which the loss can be
made good. But where, after the deduction for deprecia-
tion, there is a net profit, the case is different. Assuming
that the expenses other than the depreciation were $10,000
and the income $12,001 the balance shows :


FORM 43.
Balance Sheet.


Plant $100,000

Less depreci-
ation 2,000

Other assets .



Capital $50,000

Debt 50,000

Profit and Loss 1


In such a case the depreciation account signifies that other
assets are now held equal to the depreciation. Part of the
original plant has disappeared, but its value is represented
by other assets. Evidently so, for if a decline in the value
of one asset has not resulted in a net loss, there must, by
the most fundamental principle of double entry bookkeep-
ing, be an equivalent increase in the value of another asset.



The presence of a Depreciation Account signifies, then,
the substitution of some new, presumably some floating
asset in place of part of the value of one of the fixed assets.
Whether this implies the presence of means to replace the
old asset, or not, depends on the interpretation of the
terms used. If the new asset consists of cash, evidently
there are means on hand for replacement; if the assets
exist in the form of some new fixed asset, that in itself
does not directly give ready money. Constructively there
is power to replace because of the equivalence of assets.
Practically that power may be hindered by inability to
realize on the asset. But a similar difficulty would exist
under any circumstances; for the existence of a special
replacement fund, composed, say, of stock exchange securi-
ties might not always prevent difficulty in raising funds in
a pressing emergency. The existence of a depreciation ac-
count implies, except in a Balance Sheet showing a net loss,
the presence of new assets, that is of assets acquired since
the purchase of the plant, of equivalent value. Whether
these new assets furnish means of replacement depends
on their nature and the conditions of the general market.

An apparent exception occurs where the new wealth is
used to pay off a debt, when the Balance Sheet becomes :


FORM 44.
Balance Sheet.


Plant $100,000

Less depreci-
ation 2,000

Other assets .




Capital $50,000

Debt 48,000

Profit and Loss 1


Here the cancelation, presumably, gives an equivalent
borrowing power, and the presence of additional assets or


the lessening of debts (that is the cancelation of negative
assets) are practically identical.

In addition to the loss from wear and tear even material
goods are subject to further depreciation from economic
changes. This includes changes in the residual value due
to outside conditions, and, if it can be reckoned, the likeli-
hood that the machine will be displaced by new models
long before it is worn out. Experience may show that on
the average a given class of machinery will be serviceable
for twenty years, but that invention is so active that it is
more profitable to displace the machines and buy new
models as often as once in ten years. This is confessedly
vague and indefinite, and implies the ability to calculate
the future activities of inventive genius. The process is,
of course, constantly taking place. Indeed, the success of
American iron masters has sometimes been attributed to
the readiness with which they discard serviceable machines
in order to install new inventions. If an airship as now
made would certainly run with undiminished mechanical
efficiency for thirty years, probably no one would object
to the statement that long before that time the present
models will be displaced by some new and greatly im-
proved type, and that a calculation to that purport should
wisely be made. A more practical illustration is found in
the lasts owned by manufacturers of shoes. Materially,
these will serve for an indefinite number of years without
destruction. Practically, it is a matter of certainty that
the present models will be displaced by fashion long before
they are worn out, and, as a matter of fact, the accumu-
lated stock of out-of-date lasts is one of the serious burdens
of shoe factories. The same principle applies to patterns
used in foundries, sets of cards for Jacquard looms, and
other assets whose continued serviceability is limited by the
dictates of fashion rather than by wear and tear.

Depreciation in all such instances is scarcely to be dis-


tinguished from a reserve created to provide against con-
tingencies. If the loss of value is certain enough to be
calculable it approximates closely to ordinary deprecia-
tion ; if less certain and yet not to be neglected it resembles
rather a reserve discussed in Chapter XIII.

The depreciation, or more properly speaking, the amor-
tization of nonmaterial assets is, of course, not due to wear
and tear, but is no less inevitable. Where there is a time
limit, as, for instance, in the case of a ten years' mining
concession, the depreciation must be accomplished within
that period. In many cases it is legitimate to charge off
the value even more rapidly. Thus a copyright is likely to
become of little value before its legal termination. One
general rule is here applicable, namely: The more indefi-
nite or uncertain the value of the asset the more rigid and
rapid should be its depreciation.

The application of these general principles governing
depreciation to the various classes of assets, and the de-
termination of the proper rate to be allowed in each case
is a matter of the greatest difficulty. Material goods are
subject to depreciation for both physical and economic
causes. Physical loss or deterioration is a question whose
ultimate decision is in each case to be based on the opinion
of technical experts. Only thus can an estimate, even
approximating correctness, be made of the probable life
of the asset and its residual value. The nature of the
machine, the intensity of work, the amount of repairs, the
character of the operations, and many other technical
matters enter into the calculation for machinery. Equally
is each building to be considered by itself, for the nature
of its construction, the use to which it is put, the climate
to which it is exposed, the expenditures to be made in
repairs, and other items are effective in determining its
duration. Evidently in so complicated a problem, with so
many uncertain, if not unknown quantities, no one even


attempts minute accuracy. All the more need for making
the calculation as carefully as possible.

It is impossible to lay down specific rates of deprecia-
tion which would have any absolute value. The following
figures are those given by Dicksee, and indicate roughly
the rates which are considered satisfactory where condi-
tions are favorable. In each case the rates are based on
the diminishing value.


Engines 10 -12^ per cent.

Boilers 12^-20

Shafting 5 - 7

General machinery 7^-10

Special machinery 10 -25

Patterns 25 -33 "

Horses 15-25

Somewhat similar tables are given by Tiffany, in which
greater attention is given to buildings, and in which vari-
ations are given to correspond somewhat with details of
construction. But it must ever be borne in mind that no
general rules can be laid down and each problem must
be specifically treated. This doctrine is admirably laid
down by the Interstate Commerce Commission which when
asked to specify the rates of depreciation to be charged,
replied : ' ' Conditions under which equipment is used
vary so greatly that no uniform rate of depreciation for
all roads could be reasonably determined. The proper
rate will, of course, vary inversely with the life of the
property to which it pertains, and its determination must
take into consideration whatever affects the life of the
property. Each reporting officer should determine the
rate to be used according to such experience tables as he
may be able to construct from equipment records. ' ' l

1 Accounting Series, Circular No. 12a, p. 2, Case 109.



DELANO, F. A. The Application of a Depreciation Charge in Rail-
way Accounting. Journal of Political Economy, XVI, p. 585.
[A criticism of the rules of the Interstate Commerce Com-

DICKSEE, L. R. Depreciation, Reserves, and Reserve Funds.
London, 1903. [An important work.]

GRINLING, C. H. The Need of a Depreciation Fund in Railway
Accounts. Banker's Magazine (London), LXXV, p. 692.

GUTHRIE, E. Depreciation. Article in Encyclopedia of Account-
ing, III, p. 357. [Contains table of rates.]

MATHESON, E. The Depreciation of Factories, Mines, and In-
dustrial Undertakings and Their Valuation. Second edition.
London, 1903. [Of recognized authority, dealing with the
subject from the viewpoint of the engineer.]

TIFFANY, H. L. Digest of Depreciation. Twenty-eighth edition.
Chicago, 1890. [An elaborate table of estimated depreciation
on various kinds of property, designed for use of insurance

TURNER, S. H. Depreciation and Sinking Funds in Municipal
Undertakings. Economic Journal, XIV, p. 47. [Discusses
the duplication of charges under the English law.]

tion of operating expenses as prescribed by the Interstate
Commerce Commission. Third revised edition. Washington,

Interstate Commerce Commission. Division of Statistics

and Accounts. Accounting Series, Circulars Nos. 8 and 13,
1907. [The above documents formulate and explain the rules
of the Commission applicable to railways.]

WILKINSON, G. Depreciation and Reserves. New York, 1905.



I. Issued for Cash

THE Capital account, in the initial bookkeeping equa-
tion, represents the net wealth of the proprietor. It shows
in a single item the net value of all the items of wealth,
positive and negative, which are set forth in detail in the
various Goods accounts. If the proprietor is an individual,
the opening entry in the Capital account represents the
net wealth with which he starts his business. If it is a
partnership, separate Capital accounts are established to
show the amount contributed by each of the partners.

The keeping of the Capital account of individuals or
partnerships is extremely simple. The original contribu-
tion made by each of the proprietors is definitely known,
and there is ordinarily no doubt as to its value. This orig-
inal contribution is accordingly credited to the account
representing the capital. This is frequently headed with
the name of the proprietor, with perhaps a further state-
ment that it represents a capital contribution, and is not
a loan, thus: John Smith, Capital Account. The actual
proprietorship interest in the business, however, necessa-
rily changes from day to day with each transaction, with
the incurring of each expense, the suffering of any loss, or
the taking of a profit. While each of these changes might
logically be entered at once in the proprietor's Capital
account, there is good reason, as was shown in Chapter I,
for entering these daily changes in temporary proprietor-
ship accounts, which at stated periods, customarily at the


end of the year, are all gathered into the Profit and Loss
account. The balance of this account shows the net change
in the proprietor's wealth which has occurred during
the course of the year through business operations, or the
misfortunes incident thereto. When the net change has
been thus ascertained, it is transferred to the proprietor^
Capital account, so that at the end of each year, as at the
beginning of the business enterprise, that account shows,
as accurately as may be, the net wealth of the proprietor.
There is nothing fixed, arbitrary or conventional regard-
ing the Capital account of the private trader. If he starts
with an investment of $10,000 that amount appears as the
initial entry to the credit of his Capital account. If he
gains $2,000 profits during the year and withdraws from
the business $1,500 for outside use, the Capital account
is credited with the former sum and charged with the
latter, so that at the beginning of the new year his Capital
account again starts out with a balance, $10,500, which in
a single sum represents the net wealth of which he is for
the moment possessed. If in the second year the results
show a loss of $1,500 this, at the end of the year, is in turn
charged to the Capital account, which starts out the new
year with a balance showing that the net wealth has been
reduced to $9,000. From year to year, then, the account
shows the actual net wealth, making no discrimination be-
tween the original capital contribution, the surplus or
deficit due to business operation, or the alterations due to
withdrawals or additions of capital by the proprietor.

In corporations, however, the treatment of capital is
not so simple. The original entry does not necessarily
represent the amount of wealth which has been contrib-
uted by the stockholders; increments to the net wealth
are not annually added to the original sum, which remains
constant at the par value. The Capital account of a cor-
poration represents only the sum at which the company


is incorporated, the par value of the Capital Stock. The
actual present net wealth is obtained only by combining
with this item one or more other accounts, kept separate
on the Balance Sheet and in the ledger, which show vari-

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Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 11 of 27)