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

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the past by reason of the failure to account, as it progressed, for
depreciation, which though not apparent, was nevertheless accruing.

Moreover, with respect to public service properties likely at some
time to be valued for purchase, or the settlement of some rate or other
public question by a regulating body, or a Court, the owner may find
the Knoxville decision troublesome, tending to prevent a finding of
the real value of his property, if he has not been careful to account
for depreciation as it has accrued.

There are various methods of accounting for depreciation. In
many cases the method is prescribed by a public regulating body.
When it ia not thus prescribed, the method applicable to any given
property may depend on the law, or, with different methods conform-
ing to the law, on fairness or convenience. What is fair or convenient
may depend in part on the character of the property to be accounted
for, whether made up of long- or short-lived items, whether stationary,
growing rapidly or slowly. The method to be adopted for a given
property should accord with a reasonable interpretation of law, and
sound business principles.

Fundamental Principles. —

1. — The owner of a public utility \^ under obligation to the in-
vestors in its securities to maintain the integrity of the investment.

2. — The public is under obligation to the utility owner to pay a
fair price for the service rendered and to meet fairly its other con-
tractual obligations fairly. Of concern in the present discussion is
the obligation to include, in the fair price for service, an allowance
for the maintenance of the integrity of the investment ; that is, an allow-
ance to cover the gradual destruction or deterioration, including esti-
mated inadequacy and obsolescence, of the physical property as this
occurs. This means that when, for any ordinary reason, an item of
physical property is retired, a sum equal to its cost, or some equivalent
of this sum, paid by the people who have been served, should be in
the hands of the company owner to make good the loss due to the
retirement of the item.

It is immaterial to the maintenance of tue service how this is paid
by the people, whether in a lump sum when the item goes out of service,
or a little at a time, more or less in proportion to the gradually lessen-
ing service life of the item; but law or convenience may dictate the


manner of payment. As a matter of convenience, and of fairness to
the using public and the owner, those methods of payment should be
adopted which, conforming to law, avoid great irregularities in operat-
ing expense, in dividends, or in rates for service — that is to say:

3. — 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 respective obligations of the public and the corporation are set
forth in numerous Court decisions; the obligations of the utility to
the investors in its securities are plainly stated in the Knoxville case.

Classification of Property Units. — Simplicity of accounting re-
quires the use of different methods for different property units. It
will be plain, perhaps, that the cost of such property as fuel, oil,
waste, and supplies in general, which one can see are consumed in
quantity from day to day and from hour to hour, do not represent
investment, as the term is generally used, but operating expense; and
such property used during any fiscal period should be paid for by the
public during that period. The usual fiscal period is a year, and it
may be said fairly that the cost of any property used up during a year
is properly a part of operating expense.

This reasoning would apply also to parts of units, such as tubes of
boilers, tires on locomotive driving wheels, shingles on buildings, etc.,
the replacement of which, though not occurring annually, may be
classed as repairs rather than as renewals. The units are not retired,
they are only repaired. All replacements that properly may be called
repairs may without question be provided for in operating expense.

Closely allied to fuel and other supplies, but really representing
investment, are certain other classes of property, like telegraph poles,
railroad ties, etc. These last for a number of years, but not all of any
kind last the same number of years, and a condition gradually comes
about, in a stationary or slowly growing property, that calls for a
renewal of a certain fairly regular percentage of all the poles or all
the ties each year. The maintenance of the normal condition of poles
or ties, which condition is necessarily less than new, properly may be
charged in operating expense. The depreciation actually accruing
during any year is offset approximately by equivalent expenditures for
renewals. Simplicity of accounting does not "require" this method
of handling tie accounts, but they have nevertheless been handled in
this way. The integrity of the original investment, if that is measured
by the service life of physical items, is not maintained by this method,
because initial depreciation is not made good.

The difference between normal condition and condition new, of
such items as have been mentioned above, may be called initial decre-
tion, producing what is sometimes estimated as depreciation. Ap-


parently, under a strict interpretation of the law, such initial depre-
ciation must be lost to the owner in a valuation unless:

1. — He has collected an adequate allowance for depreciation from

the beginning; or
2. — The whole thing is ignored as not reducing the value of

the property as a going concern; or
3. — It is considered that this depreciation is a development cost

which, added to the other costs, will offset itself when full

depreciation is estimated.

Forming a link between such property, as ties and poles and the
next distinct class to be mentioned below, is such property as the
rolling stock of a great railroad. The items are much larger than
the separate ties, but the aggregate yearly expenditures for renewals
may be not more than those for ties, and in the past the cost of
renewals has been put into operating expense as the renewals
occurred, under the head of repairs and renewals; but it may be
met just as well by moneys taken from a fund, maintained by
sufficient annual contributions for depreciation from the patrons
of the utility, or by new capital furnished by the owner in
lieu of that contributed by the patrons as depreciation allowances,
but invested otherwise in the property by the owner. The Interstate
Commerce Commission now requires that reserves be set up for the
rolling stock of railroads, but, with respect to initial depreciation
existing before such reserves were established, when retirements were
handled as operating expense, the owners are situated exactly as they
are with respect to ties, and they must lose such depreciation in a
valuation unless the commissions or Courts will accept in their favor
one of the two alternatives last mentioned in the foregoing paragraph.

Theoretically, the public contribiates only the cost of the items
retired. The items purchased in place of these may cost more or
less than the items retired. Only the cost of the items retired should
be charged against the depreciation contributions, and this should
be charged, whether or not a new item is purchased.

The depreciation of certain other property units, as the very large
and costly structures of a great railroad, the cast-iron pipe lines, or
the pumping engines of a water-works property, the buildings, pipe
lines, and holders of a gas property, etc., all having long life, and
some of them involving, for the maintenance of the service rendered,
relatively large expenditures at irregular intervals, can be provided
for best without question by regular annual allowances established
for the purpose, and accruing from year to year for each item some-
what in proportion to the spent life of the item. If proper accounting
is provided, it is immaterial, except as a matter of public policy and
economy, whether the allowances for any particular item be held as


cash at interest or as convertible securities until that item is retired,
or be invested in additions or betterments to the property. In either
case the integrity of the investment is maintained.

The Replacement Method. — The replacement method is an account-
ing method which provides that the owner shall be reimbursed for
the cost of a property unit at the time it reaches the end of its service
life and is retired. That is, the cost is charged to operating expense
at that time. Operating expense being collected from the public,
it is said that the owner is reimbursed when the charge to operating
expense is made. Some owners do not charge the cost of the retired
item, but rather the cost of the item which replaces it — if such
there be — which may be more or less than the cost of the item retired.
If it is more, the public is contributing capital to this extent; if
less, the owner is losing capital to this extent. This practice is
prohibited by the Interstate Commerce Commission for large telephone
companies, although permitted for many classes of railroad property.

The replacement method is the most convenient one to use for
some short-lived property units, but, under a possible interpretation
of the law as laid down in the Knoxville case and the Minne-
sota rate cases, the method is not strictly applicable to any wasting-
property tmits, because it seems not to keep the investment intact
at all times. However, the method should be legally proper for rail-
road use for all units except equipment, because the regulating body,
the Interstate Commerce Commission, has sanctioned it, and the Com-
mittee believes that a proper interpretation of the Knoxville decision
would also permit the use of the method in some other cases, certainly
to the extent that replacements may be properly classed as current
repairs. For the language is to the effect that the public utility "is
entitled to see that from earnings the value of the property invested
is kept unimpaired," and that: "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 of parts of the property when they come
to the end of their life."

To explain the method more fully, let railroad ties be considered:
They are an elementary part of the unit known as track, and, in
estimating cost, would be an item in the inventory. If an old track
is properly maintained, about the same percentage of the ties will
be replaced with new ones each year — ties will not all disappear and
be replaced at once. In the beginning they were all new, though, in
the case of a railroad of magnitude built in one operation, some
of the ties first laid will have reached nearly the ends of their lives
by the time the whole line is completed. What will come about with
such a road will be a condition such that at any given time there will
be some ties ready to be replaced, some new ties that have just been
put in, and perhaps approximately equal numbers in all stages of


life, SO that the whole would inventory about 50% of new condition. Ties
never can be much better than this nor much worse in an old, well-
maintained track. In northern latitudes they may be a little under
normal in the spring, just before renewals begin and a little above
normal by the end of the summer, when renewals for the season have
been completed. Ties in such track are kept in normal condition
with respect to investment and service if they are kept in about 50%
condition by annual renewals accounted for in operating expense.
This is not exactly true when there is much recently added new track,
but relatively small additions do not greatly disturb the balance.

When property is maintained in this way it is said to be main-
tained under the replacement method of accounting; theoretically, the
cost of the old item is charged off, that is, credited to capital and
charged to operating expense, and the cost of the new item is charged
to capital when the replacement is made, and no accumulating depre-
ciation allowances are provided or needed. Really, no entry need
be made in the capital account unless the new item is cheaper or
more costly than the old, and, in the matter of ties, is not made usually
in any event, ties being considered much like fuel.

It has frequently been insisted that allowances for depreciation
are strictly for the purpose of making replacements, and from this
point of view property units retired without being replaced would
not be provided for by the replacement method, but, in modern account-
ing, a unit which is retired and not replaced is, and in equity should
be, treated in the same way as if it were replaced. That is, its cost
should be made good to the owner, and is made good by charging it
to operating expense.

Before describing other methods of accounting, an effort will be
made to distinguish between depreciation reserve and depreciation
funds, and to state the depreciation theories on which accounting
methods are based.

Depreciation Reserve vs. Depreciation Fund. — Depreciation re-
serve and depreciation fund are two entirely distinct and separate
things which are frequently confused, largely because of the loose
terminology used in the past by accountants, valuation engineers.
Courts, and commissions, all of whom have used the terms inter-
changeably, and have sometimes increased the confusion by speaking
of either as the "depreciation reserve fund." The depreciation reserve
represents merely the result of a series of entries on the books, made for
the purpose of preventing overstatement of earnings or property, as
will be explained later; but a fund is money or its equivalent set aside
to be devoted to some particular purpose, a depreciation fund being
set aside to provide for depreciation of property.

On the balance sheet of any enterprise, various items of assets
appear, and among these will be the value of the property. If this
property is carried at its full original value or cost on the asset side,


but has been in service some time and has lost some of its value, this
fact should appear on the balance sheet in some way, or the actual
value of the property on any given date will be over-stated by the
amount of the depreciation. Hence, in modern bookkeeping the item
of depreciation reserve appears on the liability side of the balance
sheet, which makes the property showing, at least so far as the effect
of depreciation is concerned, correct, provided the depreciation has
been properly estimated. This same result could be achieved by simply
writing off a certain part of the value of the property, carrying the
property on the asset side at its depreciated or written-off value and
making no entry on the liability side of the balance sheet. This,
however, is not considered to be as valuable a method from an historical
standpoint as that which carries property at its full value on the asset
side and sets up a reserve on the liability side of the balance sheet to
allow for the depreciation.

When a depreciation reserve is established for the balance sheet,
one or more depreciation reserve accounts are carried in the ledger.
As illustrating the use of the depreciation reserve accoimts, let it be
supposed that a certain item of property has depreciated $100 during
a given year, and that no cash has been expended for it, nor is any
expenditure to be made immediately. Although no expenditure is
to be made immediately, or has been made, the fact of the depreciation
means the consumption of $100 of invested capital, and, iinless an
entry is made to show this, the net revenue for the year will be over-
stated. Therefore, although no cash is spent, the operating expense
account is charged with $100; but, operating expense being charged
with $100 which is not spent, a surplusage of cash or its equivalent to
the amount of $100 will be found. To offset this and prevent the over-
statement of the assets, the depreciation reserve account will be credited
with $100. As time goes on, the item will continue to depreciate, and
the depreciation will be charged periodically in operating expense
and credited to the reserve account, uxitil finally the item will be
retired. At this time, assuming that it has no salvage value, it will
be written off from the property statement on the asset side of the
balance sheet, and at the same time its value must be taken from the
reserve in order still to preserve proper balance. Therefore, the reserve
will be charged with the Avhole value of the item, which, if the estimates
of depreciation from time to time have been correct, will be just equiva-
lent to the sum of the credits to depreciation reserve for this item.

Whenever a charge is made against operating expenses for deprecia-
tion, the depreciation reserve account is credited. Wlien property is
retired, the cost new less salvage recovered is charged against the
depreciation reserve. At any given date, therefore, the amount that
should appear in the depreciation reserve on the balance sheet would
be a summary of the credit balances of the various depreciation
reserve accounts appearing in the ledger. If the estimates made for


depreciation from time to time happen to agree with the fact, the
amount standing in the depreciation reserve item on the balance sheet
at any time will represent the accrued depreciation in the property,
but this is likely seldom to be the case.

The depreciation reserve exists in modern bookkeeping, whether
or not there is a depreciation fund. The depreciation fund is a part
of the assets, and is established merely by charging the fund and
crediting cash or some other asset item with any amount that at any
time may be deemed proper. This double operation does not disturb
or change the amount of the assets, but merely changes the names
under which they are carried.

It should be borne in mind that the setting aside of assets in a
depreciation fund is not charging depreciation. This is accomplished
only by making a charge against operating expenses and so decreasing
the showing of net earnings. Depreciation is not provided for imtil
it is charged in operating expense, and it is not deducted from the
property until it is credited to depreciation reserve, or written oS
from the property statement on the asset side.

Practically, of course, collection may be made from the public
without any depreciation entry in the books, that is, enough may be
collected in rates to pay operating expense, depreciation, and fair
return, but that part which should be applied to the property to cover
depreciation may be otherwise disposed of, as, for instance, distributed
as unwarranted dividends; and, when this is done wittingly, a theft
has been committed from the property, and, when done unwittingly,
error of management is shown. The argument in the foregoing para-
graph assumes an honest and proper management.

Under the replacement method of accounting, there would be neither
depreciation reserve nor depreciation fund, the reserve being estab-
lished only when operating expense is charged without expenditure
of cash, and under this method at any time the property
will be over-stated by the amount of the depreciation accrued but
not yet realized through retirements.

If no charge is made to operating expense or credit to reserve for
depreciation of an item previous to its abandonment, but specific assets
are set aside as a fund to offset the accruing depreciation of the item,
"depreciation fund" will appear among the assets, but, as before, the
profits and the property will be over-stated at any time by the amount
of depreciation accrued but not realized by retirement.

Depreciation Theories. — Depreciation of physical units used in con-
nection with public utilities, or, indeed, with any other industries,
does not proceed in accordance with any mathematical law. One
unit, identical with another, and used for the same purpose in the
same way, goes out of service before the other, perhaps because of
some accident; or a unit goes out of service before it is worn out,


because of some new invention that displaces it, or some new require-
ment of service that makes its use no longer possible; another unit,
performing hard service, requires so much more repair during its
later than during its earlier life, and yields so many fewer units of
service per unit of time, that, long before it is actually worn out, it be-
comes uneconomical to use it, and it is replaced some time before it is
incapable of service. There is no regularity in the development of
the increasing need for repairs; there is no regularity in the progress
of depreciation; but, in order to devise a reasonable plan for laying
aside allowances from year to year to make good the depreciation
as it accrues, and to provide for the accumulation of a sum equivalent
to the cost less salvage of a unit by the time it is retired, some theory
of depreciation progress must be assumed on which such allowances
may be based. Several such theories have been suggested, and corre-
sponding accounting methods have been developed for some of them
and have been adopted by accountants and approved by Courts and
commissions. Three of the more generally mentioned theories will
be explained, namely: The straight-line theory, the compound-interest
theory, and the unit-cost theory; and the corresponding accounting
methods will then be discussed.

The Straight-Line Theory.— The straight-line theory assumes that
depreciation progresses uniformly from the beginning of service to
the end of service life; that when service life is half gone, value less
salvage is half gone, when service life is nine-tenths gone, value less
salvage is nine-tenths gone. Thus, if a unit cost $100 and has a
salvage value of $10, after an estimated total service life of 10 years,
and has been in service for 5 years, it has depreciated in value one-half
of $90, or $45, and is worth $45 plus $10 salvage, or $55; if it has
been in service 9 years, it has depreciated $81 and is worth only $19.
This is the simplest depreciation theory, and because of its simplicity
it has been widely adopted. Its application in accounting and valu-
ation is sometimes attended with certain apparent inequities which
will appear in the discussion of accoxinting under this theory.

The Compound-Interest Theory. — This theory assumes that depre-
ciation progresses at the same rate as a sinking fund grows from an
annuity accumulating at compound interest. Thus, if a unit cost $100
and has a salvage value of $10 after a total service life of 10 years, an
annuity may be determined such that, with its accumulation of in-
terest, it will equal $90 at the end of 10 years, and the depreciation
of the unit at the end of any year will be equivalent to the accumula-
tion of the annuity and its accretions to that time. If the rate of
interest be r; the cost less salvage of a unit be C ; and the estimated
service life N years; the annuity necessary to set aside to equal G
in N years is given by _

-» - (1 + Jr- 1 ('>


and the sum to which this will amount in n years is given by

" = -7 1 + ry- 1 (2>

This may be solved by logarithms, or the result may be taken from
amortization tables, many of which have been published covering
Equations (1) and (2). In applying these equations to a particular
example, let it be assumed as before that a service unit costs $100,
has a salvage value of $10 after a total service life of 10 years; that
it has served 5 years, and that interest is at the rate of 5 per cent.
Then $90 must be accumulated in 10 years, and the necessary annuity,
A, at 5% is $7.16. This annuity, with its accumulation of interest,
will amount to $39.54 in 5 years, and the unit is then worth $50.46
plus $10.00 salvage, or $60.46. After 9 years of service, the depreci-
ation amounts to $78.90, and the unit is worth $11.10 plus $10.00 sal-
vage, or $21.10. The depreciation during any one year is equivalent to
the annuity for that year plus the interest on the accumulation of
previous annuities and interest.

This theory may have a certain practical advantage over the

Online LibraryAmerican Society of Civil EngineersTransactions of the American Society of Civil Engineers (Volume 81) → online text (page 130 of 167)