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Transactions of the American Society of Civil Engineers (Volume 81) online

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And, finally, the estimator must have the will to refuse to make
estimates for work that he does not understand.




Depreciation in Valuation.- — Perhaps there is no single subject in
connection with valuation that has caused more trouble than deprecia-
tion. This has been due to various causes, perhaps not the least of
which has been confusion in the use of the term. Depreciation is some-
times used to mean decretion, which is loss of service life, sometimes
to mean the money allowance made in the bookkeeping to offset
accruing loss of service life, and sometimes the loss of value existing
at any time due to the loss of service life or any other cause. The
Committee will use it only as meaning the loss of value or worth of
property units which are parts of going concerns. Although this may
be due to many causes, the general discussion will include considera-
tion only of those effects which, like wear and tear, age, use, and
obsolescence, or inadequacy, bring a physical property unit gradually
to the end of its service life.

Another difficulty has been the failure of owners and Courts to
comprehend depreciation. Neither of these have realized in the past
the necessity for and equity of earning and setting aside allowances
to provide for accruing loss of capital due to the accruing, but not yet
total, loss of service life of the parts of a property. Nor is this difficulty
wholly removed at the present time. In the earliest decisions of the
United States Courts bearing on this subject (Union Pacific R. R. Co.
V. United States, 99 U. S., 402, and United States v. Kansas Pacific Ry.
Co., 99 U. S., 455, both decided October, 1878), it was held: in the first
case, that all expenses for maintenance of the property should be
included in operating expense, only cost of original construction and
subsequent enlargement and improvement of the works being capital
expenditures; and it was even held that ordinary betterments wisely
might be made from earnings, apparently without a charge to capital,
a practice now generally disapproved by Courts and commissions; and
in the second case, that no allowance for depreciation that does not
represent cash actually spent can be included in operating expense.

Nineteen years later the Supreme Covirt of California (in San
Diego Water Co. v. San Diego, 118 Cal., 556, 1897), mentions depre-
ciation, and in the prevailing opinion given by Justice Van Fleet,
reinforced by the concurring opinion of Justice Garouette, distinctly
holds that an allowance should not be collected from the rate-payers
for it, the concurring opinion saying:

"But such a thing is all wrong, for it results in the consumers of
water buying the plant and paying for it in installments."


But it is fair to say that this concurring opinion is based on the
notion that such things as tunnels, wells, reservoirs, water rights, and
real estate suffer no depreciation;

"* * * there is no wear and tear, no permanent and gradual
destruction by use and age. Most of them stand everlasting as the

and that it further admits that the replacement of worn out items is
a proper charge to operating expenses, saying:

"If improvements are made in the plant as it stands, as, for example,
a new pipe substituted for an old piece of the same size and quality,
such charge should be considered operating expenses."

which seems clearly to uphold what will be described later as the
replacement method of maintaining property that is supposed to wear
out. The decision makes the mistake of finding that certain items of
property which do go out of service for one reason or another are ''ever-
lasting as the hills."

It is interesting to note that there was a dissenting opinion, handed
down by Chief Justice Beatty, which says that after including as cur-
rent expenses all operating expenses reasonably and properly incurred,
taxes, and the cost of current repairs, there should be added to the sum
to be collected annually an allowance for a sinking fvtnd sufficient
to replace any parts of the plant which, at the end of a term
of years, will be so worn out as to require restoration, when this restora-
tion occurs.

The foregoing is introduced because of the appearance, apparently
for the first time, of a discussion of the propriety of collecting and set-
ting aside a depreciation allowance, and particularly the approval of
such a course as given in the dissenting opinion. A year later, the
same Court (in Eedlands, etc.. Water Co. v. Redlands, 212 Cal., 312,
1898) said:

"In a municipal ordinance fixing rates * * * the water com-
pany is not entitled to be reimbursed from the income derived from
rates, fixed by the ordinance, for interest upon its indebtedness, nor for
depreciation of its plant, aside from the amount requisite for its main-
tenance and repairs during the year."

This decision was consistent with that in the San Diego case, and
referred to it, and is here quoted because the United States Supreme
Court (in San Diego Land and Town Co. v. Jasper, 189 TJ. S., 439,
1903) referred to this case with approval. And this was as late as
1903. The language used at page 446 of the report is as follows :

"We will say a word about the opposite contention of the appellant
that there should have been an allowance for depreciation over and
above an allowance for repairs. From a constitutional point of view
we see no sufficient evidence that the allowance of six per cent, on the
value set by the supervisors, in addition to what was allowed for


repairs, is confiscatory. On the other hand, if the claim is made under
the statute, although that would be no ground for bringing the case to
this court, it has been decided by the Supreme Court of California that
the statute warrants no such claim."

Four years later, at least one Court had seen a light, for (in Per-
kins V. Northern Pacific Ey., 155 Fed., 445, 1907) Judge Loehran, of
the Circuit Court of Minnesota, states, among other things:

"It is evident * * * that a railroad, like everything else, will
wear out in time, and they have been used so long in this country that
there can be a reasonable estimate of the percentage of loss each year
from depreciation of the roadbed, culverts, bridges, and rolling stock;
that it would be proper to lay aside a reasonable amount to furnish
replacements, renewals, and repairs when needed; and that if that was
not done the railroad company might soon be in a position in which it
could not keep up, with the rates that it was getting, and maintain its
property in an efficient state to render such service as the public is
entitled to receive from it. Now this is a matter in which the public has
an interest as well as the railroad companies and the stockholders of
the railroad companies."

"There is a danger that this feeling of selfishness may lead them
too far and reduce this compensation so much that it will not enable
the railroads to serve them with efficiency — to keep up their roadbed,
culverts, bridges, and everything so that they will be entirely safe for
the transportation of passengers and freight, and to keep the rolling
stock in the best state of efficiency and enable them to provide the
best service attainable, and that is exactly what those corporations
are required to do. They are required to exercise the highest degree
of care in relation to the transportation of passengers, and a high
degree of care in relation to the transportation of freight, and it is
certainly for the interests of the people that they should be enabled
to do this; and it would be a very short sighted policy which would
reduce the compensation of these railroads to a degree that would
disable them from performing these services fully and fairly for the
benefit of the people."

It was not until 1909, however, that the Supreme Court of the
United States recognized the character of depreciation and the
necessity for collecting an allowance to cover it as it, accrues. This
recognition appears in the decision handed down by Mr. Justice Moody,
in what has come to be known as the Knoxville case. (City of Knox-
ville V. Knoxville Water Co., 212 U. S., 1, decided January 4th, 1909.)

This decision, here quoted somewhat at length, holds that, not only
is it proper to set aside periodically an allowance to cover the accruing
loss of value of aging property, but that it is the plain duty of operat-
ing companies so to do and to collect, from the public served, enough
to maintain at all times the value of the investment unimpaired.

It also holds that though the cost of reproduction is one way of
ascertaining the present value of a plant, like that of a water company,
which has been in use for many years, the test would lead to obviously


incorrect results if the cost of reproduction is not diminished by the
depreciation which has come from age and use.

"The cost of reproduction is one way of ascertaining the present
value of a plant like that of a water company, but that test would lead
to obviously incorrect results, if the cost of reproduction is not di-
minished by the depreciation which has come from age and use. The
company contends that the master, in fixing upon the valuation of the
tangible property, did make an allowance for depreciation, but we are
unable to agree to this. The master nowhere says that he made allow-
ance for depreciation, and the language of his report is inconsistent
with such a reduction. The figures which he adopts are those of a
'fair contractor's price.' The basis of his calculation was the testi-
mony of an opinion witness called from the company. That witness
submitted a table, which avowedly showed the cost of reproduction,
without allowance for depreciation. The values testified to by him
were adopted by the master in the great majority of cases. The wit-
ness's valuation of the tangible property was somewhat reduced by the
master, but the reductions were not based on the theory of deprecia-
tion, but upon a difference of opinion as to reproduction cost.

"The cost of reproduction is not always a fair measure of the
present value of a plant which has been in use for many years. The
items composing the plant depreciate in value from year to year in
varying degree. Some pieces of property, like real estate for instance,
depreciate not at all, and sometimes, on the other hand, appreciate in
value. But the reservoirs, the mains, the service pipes, structures upon
real estate, standpipes, pumps, boilers, meters, tools and appliances of
every kind begin to depreciate with more or less rapidity from the mo-
ment of their first use. It is not easy to fix at any given time the
amount of depreciation of a plant whose component parts are of differ-
ent ages with different expectation of life. But it is clear that some
substantial allowance for depreciation ought to have been made in this
case. The officers of the company, alio intuituOj estimated what they
called 'incomplete depreciation' of this plant (which we understand
to be the depreciation of the surviving parts of it still in use) at $77 000
which is 14 per cent, of the master's appraisement of the tangible

"A witness called by the city placed the reproduction value of the
tangible property at $363 000, and estimated the allowance that shoiild
be made for depreciation at $118 000, or 32 per cent. In the view we
take of the case, it is not necessary that we should undertake the diffi-
cult task of determining exactly how much the master's valuation of
the tangible property ought to have been diminished by the deprecia-
tion which that property had undergone. It is enough to say that there
should have been a considerable diminution, sufficient at least to raise
the net income found by the court above 6 per cent, upon the whole
valuation thus diminished.

"The company's original case was based upon an elaborate analysis
of the cost of construction. To arrive at the present value of the
plant, large deductions were made on account of the depreciation.
This depreciation was divided into complete depreciation and incom-
plete depreciation. The complete depreciation represented that part


of the original plant which through destruction or obsolescence had
actually perished as useful property. The incomplete depreciation
represented the impairment in value of the parts of the plant which
remained in existence and were continued in use. It was urgently
contended that, in fixing upon a reasonable return, the amounts of
complete and incomplete depreciation should be added to the present
value of the surviving parts. The court refused to approve this
method, and we think properly refused. A water plant, with all its
additions, begins to depreciate in value from the moment of its use.
Before coming to the question of profit at all, the company is entitled
to earn a sufficient sum annually to provide, not only for current
repairs, but for making good the depreciation and replacing the parts
of the property when they come to the end of their life. The company
is not bound to see its property gradually waste, without making
provision out of earnings for its replacement. It is entitled to see
that from earnings the value of the property invested is kept unim-
paired, so that at the end of any given term of years the original
investment remains as it was at the beginning. It is not only the
right of the company to make such a provision, but it is its duty to its
bond and stockholders, and, in case of a public service corporation
at least, its plain duty to the public. If a different course were
pursued, the only method of providing for replacement of property
which has ceased to be useful would be the investment of new capital
and the issue of new bonds or stocks. This course would lead to a
constantly increasing variance between present value and bond and
stock capitalization — a tendency which would inevitably lead to
disaster, either to the stockholders or to the public, or both. If, how-
ever, a company fails to perform this plain duty and to exact sufficient
returns to keep the investment unimpaired, whether this is the result
of unwarranted dividends upon over-issues of securities, or of omission
to exact proper prices for the output, the fault is its own. When,
therefore, a public regulation of its prices comes under question, the
true value of the property then employed for the purpose of earning
a return cannot be enhanced by a consideration of the errors in man-
agement which have been committed in the past."

This decision has been supported in all subsequent decisions of
the United States Supreme Court having to do with the matter, and
therefore it stands to-day the law in this country. Questions of
interpretation have been raised by public utility owners, lower Courts
have not all followed the decision literally, and there are certain
practical questions arising in connection with the determination of
depreciation in the valuation of a property, all of which require careful
consideration and will be discussed in this chapter.

Depreciation being defined primarily as loss of value or worth,
the depreciation that is of concern in valuation proceedings is that
which is measured by the sum that 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." The Commit-
tee will call this the "depreciation of valuation", or "fair depreciation".

valuation of public utilities 1453

Three Aspects.

The Committee will consider depreciation from three aspects:

1. — The cause — decretion or loss of service life of physical property;
■J. — The record — accounting depreciation;

3. — The amount sought — the depreciation of valuation, or fair

By "decretion" is meant that loss of service life of a physical prop-
erty, or property unit, or item, which may be estimated by an inspec-
tion of the property, considering the history of its past service and
the probable character of its future service, the method and character
of its maintenance, and all other pertinent facts concerning it. It is
the fact of loss of service life, regardless of its effect on value or any-
thing else. Consciously or unconsciously, the result will be expressed
as a fraction of the estimated total service life (elapsed life plus
expectation of life) of the property, or property unit, or item,
and this must be converted into a corresponding fraction of cost, in
order to find the loss of value resulting from the decretion. Some
minds may not consciously go through the elementary process, but
will estimate at once the final money sum.

By "accounting depreciation" is meant that sum which, in the book-
keeping of the owners of the property, has been charged to operating
expense and deducted from the capital, either directly or by setting up
a reserve, to allow for an estimated or actual depreciation of a property
unit or item. A definition conforming to methods prescribed by the
Interstate Commerce Commission is the sum charged to operating
expense to provide a reserve* to cover the cost less salvage of a given
property when it is retired from service. Accounting depreciation
may or may not be equivalent to the actual or fair depreciation at any
time. Whether or not it is approximately equivalent, will depend on
the methods used and the accuracy of the forecast of service life of
the property units or items.

The "depreciation of valuation" or "fair depreciation" has been
defined above.

In valuation discussions, depreciation cannot be treated wholly
independently of its cause or of accounting methods, but, so far as
possible, the Committee will consider : first, only decretion or the
cause; second, only accounting depreciation; and, third, the deprecia-
tion of valuation.


Causes of Decretion. — Decretion may be due to use. A machine
may have been purchased new, may have been in use a year, may show
no signs of wear, and yet experience tells that the machine when new

* For a definition of this term, see p. 1460.


was probably good for only 10 years. One of these years has elapsed;
the machine is as valuable in its present output of service as ever it
was, but, a year of its life has gone into service, and hence, approxi-
mately one-tenth of the life of the machine must be estimated as gone,
and therefore decretion exists to that extent. Examination of
the particular machine may lead the examiner to estimate that it has
still 11 years of service before it, in which case its total life will be
estimated at 12 years, and only one-twelfth of its service life will
be gone. Examination always should be made, and consideration
should be given to the character of past and probable future service,
and the method and character of maintenance, because, on all these
will depend the estimate of total service life. Units of service may be
of more consequence than years of service in estimating service life.

Decretion may be due to age alone, as some properties grow old
regardless of the use to which they are put. Sometimes this aging
depends on the care given the properties. Wood decays, iron oxidizes,
brick disintegrates, even stone is destroyed by the elements, some
kinds more rapidly than others. The particular use to which these
substances are put, whether in sheltered or exposed situations, may
determine the rate of decretion, which for some uses may be pi'ac-
tically or actually nil, within the range of human estimates. The
effect of weathering often may be overcome by periodic repairs, and
a given structure may remain in use for many years, and even per-
petually, the structure of a given day having in it no item that was
in it when it was first built. Such structures will always show some
physical deterioration — the immediate or approaching need of some
replacements or repairs.

Decretion may be due to immediate or approaching inadequacy.
A given machine may be doing a work of constantly increasing mag-
nitude which now or later will require a larger machine before the
present one is worn out. The present machine may be good for
a considerable service within its capacity. It may have, therefore, a
large salvage value, but, for the purpose for which it is being used,
it is approaching the end of its service life.

Decretion may be due to obsolescence. A machine may belong to
a class that is more or less rapidly changing patterns and forms, due
to an advancing art or science. Long before it is worn out, new forms
may have been devised which are so much more efficient that it may no
longer pay to keep the old machine in service. Or advancing civiliza-
tion, growth of population, and changing character of social life may
call for a different service from that rendered with satisfaction to the
people served under the old conditions. This sort of decretion is not
due to inadequacy, but to obsolescence.

The several causes mentioned may exist singly or together in a
given plant, or plant unit.


Decretion of a plant unit may also be caused by accident.
Decretion always Present in a Going Property. — Decretion is likely
to exist in almost every physical item of a going property except land.
Even the Pyramids are slowly passing away, and, between items of very
long life and those, like working tools, of very short life, there are all
degrees of length of service life. Some properties, like water-works
or gas properties, are essentially all new when they begin to operate,
because, though some pipes may have been in the ground for some
time, their total service life is so long that this preliminary exposure
to decay may be neglected. Shortly after a water or gas property
begins to operate, its machinery and structures have begun to deterio-
rate, and could not be inventoried as new, even for the purpose for
which they are used, although they may be giving just as efficient
service as new machinery and structures could give. Other properties,
like railroads, have some items that are essentially old when regular
service begins. Ties, for instance, begin to decay with some rapidity
as soon as they are laid in the track, and often by the time a newly
created extensive property has reached the operating stage they are
being replaced almost or quite at the usual normal rate on the older
part of the road.

Due to these facts, no going property could ever be inventoried as
new if taken item by item or unit by unit, because some of the service
life of practically every item or unit will have passed. As a result
of this fact it can be shown that when the properly weighted average
of all the decretion of the various units of a well-maintained railroad,
for instance, is found, the railroad property as a whole cannot show
more than from 80 to 90% of new condition, or there is estimated,
say, 15% loss of value due to decretion of various units.

The Troublesome Problem. — Although, in a well-maintained prop-
erty, decretion is always present in some degree, yet in some cases this
decretion, converted into loss of value, 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 depre-
ciation. 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 of reproduction new, when finding fair value for any purpose, is
the great troublesome problem of depreciation in valuation. This prob-
lem will be discussed after explaining accounting depreciation.

Accounting Depreciation.
General Statement. — To understand accounting depreciation, as
defined in the Glossary, it is necessary to know something of the
fundamentals of methods of accounting for depreciation. Bringing


depreciation into the accounts of a company owner is one of the steps
necessary to keep the earnings and property statements correct.

Many owners have not understood, and some do not now under-
stand, the necessity for charging off depreciation as it accrues. Sooner
or later, such owners are brought face to face with the necessity of
renewing plant units with no means available, because profits have
been over-estimated and a part of the capital has been distributed in

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