CHAPTER VII

DEPRECIATION—ITS CAUSES Analysis of Causes Most definitions of the term depreciation set the boundaries or limits of its meaning by naming the causes. These are normally: (1) wear and tear, or physical factors; (2) inadequacy and obsolescence, or functional factors; and (3) accidents or contingent causes. This statement of causes applies specifically only to physical or tangible properties. In the case of intangible property, consisting for the most part of rights of various sorts, the controlling cause is usually merely lapse of time. The chart on the following page analyzes the various causes and shows their detailed ramifications. Age as a Cause of Depreciation The physical depreciation of tangible properties arises from two main causes, viz., the wear and tear from operation and the use of the asset and the wear and tear of age, known as decrepitude. Immediately upon the installation of an asset the forces of time and the elements begin their ravages even before operations begin. As H. R. Hatfield[20] trenchantly puts it, “all machinery is on an irresistible march to the junk heap,” and the statement is equally applicable to all other forms of wasting assets. The ties placed on the roadbed of a railway, conduits put in place for carrying water, gas, steam, electric current, or oil, rolling stock, poles for telephone and telegraph lines, buildings, even interior installations of various types—all are subject to the normal ravages of time and the elements, and nothing which man has been able to devise can do more than retard the inevitable. Thus, all assets decrease in value through the inevitable lapse of time. Attention should be here directed to the fact that decrepitude depends on the _normal_ action of time and the elements, whereas accidents due to action of the elements (listed in the chart on page 121, under III, 1, b) are of an _abnormal_ character and cannot usually be taken into full account at the time of the installation of any particular piece of property. CAUSES OF DEPRECIATION[21] { { 1. Wear and Tear from Operation { I.Physical { (a) Maintenance Policy { { 2. Decrepitude { { (a) Action of Time and the Elements { { II.Funct- { 1. Inadequacy or Supersession { ional { 2. Obsolescence { { { (a) Negligence { { { { Fire { { { { Lightning { { 1. Accidents { (b) Elements { Wind A. Tangible { { { { Water Property { { { { Temperature { { { (c) Structural Defects { { { { { (a) Parasites { III.Contin-{ { (b) Pollution of Water { gent { { { Mineral { { 2. Diseases { (c) Growths in { Vegetable { { { Water-Mains{ Animal { { { (d) Electrolysis { { { (e) Crystallization { { { { 3. Diminution in Supply { (a) Natural Gas { { { (b) Water B. Intangible Property—Rights { 1. Limited in Time { 2. Abandoned [20] In “Modern Accounting.” [21] Chart adapted from “Regulation, Valuation and Depreciation,” by S. S. Wyer. Wear and Tear of Use The wear and tear due to use or operation usually has a much more potent effect on the service life of an asset than that due to decrepitude. The established policy as to repairs and maintenance has an important effect on this kind of depreciation. Sooner or later every machine becomes unfit for service, due to the friction of its parts, the strains to which it is subject under normal load, those of much greater effect under abnormal load, the method of applying its power, etc. It must then either be withdrawn from service and completely depreciated, or it must be repaired in an effort to lengthen its life. It should be kept in mind that the determining factor here is efficiency. The serviceability of the machine must be kept up to a recognized standard through adequate expenditures for repairs and up-keep until the cost of up-keep is disproportionate to the service rendered, or until the machine becomes so decrepid as to make its operation hazardous. The application of theoretical depreciation to operating wear and tear must proceed with great care. This is so because of the varying factor of maintenance. If the cost of maintenance Could be standardized, experience under such standard would give a reliable basis for the calculation of the depreciation charge. Since adherence to such a standard is difficult or impossible under the conditions that are constantly arising in a given establishment, the depreciation policy must of necessity be based on actual observation and inspection by experts. The expenditure necessary to restore an asset to a state of operating efficiency is called “deferred” or “accrued” maintenance, and it is the amount of this at a given time, estimated by expert inspection, which compared with normal maintenance forms the basis for an estimate of the depreciation charge. Functional Depreciation Tangible property is subject also to “functional” depreciation. This means a lessening in worth or service value due to causes, other than those already treated, which interfere with and operate against the proper functioning of the asset, making it impossible to render effectively and economically the _full_ requirements of service expected of it. This inability to fulfil its proper function may result either from inadequacy or obsolescence. “Thus the structure may suffer total depreciation and be thrown out of service, not only because through wear and tear it has reached a condition where further expenditures for repairs or attempts to make it suitable for the required service would not be economical or expedient, but also because recent improvements, or new inventions, new developments and radical changes in service, or the demands of one kind or another involving sweeping changes in the existing plant, make abandonment necessary.”[22] [22] Leonard Metcalf paper on “Water-works Valuation and Fair Rates” before the American Society of Civil Engineers, Vol. LXIV, 1909, page 16. Inadequacy as a Factor Inadequacy is a condition in which the asset is found unable to meet the demands made upon it, due usually to growth of business or to some rearrangement made necessary by changed policy before the asset has reached the end of This condition is also called “supersession.” For economical operation the asset must be discarded and superseded by a larger unit. As an example, dynamos and motors of a capacity sufficient to meet all demands on them at the date of their installation may, through growth of business, prove entirely inadequate after a few years to meet the service expected of them. Inadequacy as a factor of depreciation will have no appreciable effect in cases where the demand is fairly constant and the market does not permit of much expansion. Where there is a growing community and (or) a growing appreciation of the commodity manufactured, demand may increase to a point where original judgment and expectation will be shown to have been in error and the equipment will have to be superseded if advantage is to be taken of the expanding market. Two main factors or compelling forces may bring about inadequacy, viz., those of internal origin and those of external origin. Those of internal origin may become effective because of: (1) abandonment of original financial policy, (2) considerations of engineering economy, and (3) unforeseen development. Inadequacy through Change of Policy Perhaps the best illustration of the first type is that of a plant built to supply a certain commodity to the local community. A change in ownership brings about an abandonment of the original policy and a determination to provide neighboring communities with the commodity also. This change in policy frequently comes about when several smaller plants are merged under one control and the original units are found to be entirely inadequate to meet the demand. Again, when through a change in financial policy it is decided to lower the rates of a public service commodity, the original equipment may prove inadequate to meet the increased demand. It is not contended here that this type of inadequacy is to be taken into account in estimating the depreciation charge. Usually it cannot be foreseen and should therefore be provided against under the head of a general contingent reserve or appropriation of profit. If it can be foreseen intelligently, it should be taken into account in the estimate of depreciation. Inadequacy through Motives of Economy The second type of inadequacy may be a foreseen and calculated inadequacy. In a new community or in the case of a new commodity whose virtues are little known, it may be the part of economy and business sagacity to install originally only such equipment as will be adequate to meet the requirements during the development stage and then when the commodity is introduced and established to discard the old and install larger and more adequate structures. Although it may be foreseen with reasonable certitude that a power plant generating a thousand horse-power will be entirely inadequate in ten years, yet it may be the better business economy to scrap it at the end of ten years rather than incur the up-keep and depreciation charges on a larger plant which would give longer service. Whichever policy, according to best engineering economy, results in the lowest unit cost of product is usually the determining factor. If with all the facts and reasonable expectations under view the smaller plant is decided upon, then assuredly the depreciation due to inadequacy must be taken into consideration. Inadequacy Due to Unforeseen Development The third type of inadequacy, unforeseen development, has been shown to be due to an _unexpected_ expansion of the market. This may be brought about by growth in population of the present market, growth in appreciation of the commodity manufactured, or sometimes by a lowering of transportation rates whereby new markets are opened. The very fact that this kind of inadequacy is _unexpected_ and _unforeseen_ makes impossible its inclusion in the current depreciation charge. This kind of inadequacy is revealed by a post-mortem determination of causes of which there were no symptoms leading to a correct diagnosis during life. The loss to be incurred through the scrapping of the property before its expected termination of service is a loss which must be borne by the future and not by the past. It is in the nature of a development cost which must be incurred if the opportunities of the new market are to be seized, and which must enter into a consideration of the advisability of making a bid for the new business. Business policy might or might not dictate that these costs be charged against reserves of profits from the past. Theoretically they should be spread somewhat evenly over the future but in neither case can they have any place in present depreciation charges. It should be thoroughly understood that depreciation is a charge which relates always to the past, never to the future. There is no contradiction here in that a consideration of the future must help to determine the amount of waste which has taken place in the past. P. D. Leake[23] says: “It is a misconception to describe the annual provision for depreciation as a provision for future renewals, as though it has reference to the future. The annual provision for depreciation has nothing to do with the future but relates solely to the past. It is a replacement of capital in respect to past capital outlay expired in the process of carrying on the business.” [23] In “Depreciation and Wasting Assets.” Inadequacy Imposed from Without Inadequacy may be imposed by external forces or authority. In public service utilities this has often proved a source of expense. In the interests of a supposedly enlightened opinion—oftentimes a badly mistaken opinion—present equipment is found inadequate to meet the new demands. This type of inadequacy merges imperceptibly into obsolescence. Again, a municipality at the time of repaving the streets may require that the utility company discard present equipment and install a larger and heavier type; it may require that overhead wires be carried in underground conduits; and prudence on the part of the company may lead to the installation of larger carriers than the old. These losses—and there is almost invariably a loss to the utility company—must be charged against the future. So also, the passage of laws and ordinances in the interests of sanitation and fire protection frequently compels the private owner to discard equipment and devices before their service life has passed and install more adequate equipment. Obsolescence as a Cause The second factor of functional depreciation is obsolescence. By this we mean that lessening in worth which is brought about by the development of something new whereby production becomes more economical or is changed to meet new ideas, fads, or fancies of the consumer. Obsolescence may be imposed by outside forces through the exercise of the police power under circumstances analogous to those mentioned under the discussion of inadequacy brought about by external means. Municipalities and regulating commissions have speeded up the “irresistible march to the junk heap” in numberless instances. Cotton-spinning and shoe machinery, lasts and patterns of all sorts, electrical devices in particular—all have been subject to obsolescence charges. The horse car gave place to the cable car, which in its turn was displaced by steam locomotion, and today this has given way to electrically propelled street cars. The old wooden rail gave way to the rail of wood capped with a strip of steel, the light “T” steel rail, and the present heavy steel rails—changes all necessitated by changes and developments in the art and a demand for better service by the public. The stick used by the Indian to turn the ground and plant his corn has been displaced successively by hand tools of iron and steel, horse-driven plows, and the big steam and gas tractors of the present day. No industry has escaped the seemingly inevitable trend towards the displacement of the old and antiquated but not worn-out equipment, by newer, more up-to-date, and more economical equipment. Obviously the last word has not yet been spoken or the last refinement been made in the development or application of art and science to any industrial enterprise. Life means development; dry rot and retrogression are the fate of any art, any industry, any people which has reached the limit of its development. Since, therefore, obsolescence is so common an occurrence, so absolutely a fact of general experience, it would be folly to ignore it. Many writers and some authorities have said that while obsolescence is as certain and ever present as the forces of nature, it seldom is more possible of measurement than are they. However, engineers tell us that in most cases it is possible for qualified experts to foretell with _reasonable_ certainty the effect of obsolescence. “Those most familiar with the art know the units which will be able to serve their entire physical life, and what classes are so uneconomical or otherwise defective that some improvement must be expected.” Treatment of Obsolescence As to the effect of obsolescence, attention should be called to the fact that it is seldom operative to its full extent. The decision as to the exact time of discarding the old and installing the new rests on a nice balancing of many factors. Thus, the safety devices operated by hand on railroads are not displaced in a wholesale manner by those which operate automatically. In a large telephone company old switchboards are not discarded for new over the entire system at the same time. Much of the old is oftentimes allowed to serve out its life-term, and obsolescence has no effect. Under the circumstances stated above, and many similar and more complicated conditions, it requires a nice calculation to determine the actual effect of the factor of obsolescence in depreciation. Many inaccuracies, even many ridiculous conclusions, in estimates made by experts are met with, times without number. The novice thus fears even to guess as to the amount of the depreciation due to this factor. That is perhaps as it should be; there is no place here for the novice. Inasmuch, however, as the trend is to estimate the depreciation due to obsolescence, and such practice has the unqualified approval of many public service boards and at least the silent approval of our courts, it would seem that an attempt should be made to include it in the depreciation charge. As to its sufficiency or insufficiency, an amount can be estimated with as much accuracy under the head of depreciation as under that of a contingent reserve, and the former course is to be preferred in that an inevitable fact of experience in almost every industry is thereby recognized. The past, and not the future, is thus burdened with the accomplished waste. There doubtless will be instances where depreciation due to obsolescence palpably cannot be foreseen. For such there is but one of two courses, viz.: either to charge it against profits reserved out of the past, or burden the future with its cost. Relative to the inclusion of obsolescence in the depreciation charge, the Illinois Public Service Commission says in the case of the City of Springfield v. Springfield Gas and Electric Company, March, 1916: “In view of all the facts in this case, the Commission finds that it is but reasonable, proper, and equitable to make deductions from cost new to cover accrued depreciation, both physical and functional....” The statement of the Maryland Public Service Commission in the case of the Chesapeake and Potomac Telephone Company of Baltimore City has already been cited on page 106. Quoting from the report of the Valuation Committee of the American Society of Civil Engineers: “A limited search ... indicated that inadequacy and obsolescence were included either in ascertaining the amount of depreciation to be included in cost, or to be deducted from earnings ... by the commissions of the following states: Arizona, California, Colorado, Illinois, Maryland, Massachusetts, New York, Oregon, South Dakota, Wisconsin.” Covering this feature, i.e., the depreciation feature, in making returns to the government under the Federal Income Tax of 1916, the Commissioner ruled as follows: “The deduction for depreciation should be the estimated amount of the loss, accrued during the year to which the return relates, in the value of the property in respect of which such deduction is claimed, that arises from exhaustion, wear and tear, or obsolescence out of the uses to which the property is put.... The depreciation allowance, to be deductible, must be, as nearly as possible, the measure of the loss due to wear and tear, exhaustion, and obsolescence.” Although not specifically mentioned, functional depreciation may be said to have the sanction of the United States Supreme Court in its decisions covering the Knoxville and Minnesota rate cases. In the case of the Des Moines Water Company v. City of Des Moines, 192 Fed. 193, September 16, 1911, the court allows both “functional and physical depreciation.” It would seem, then, that the legality of the practice is pretty well established and the ability to compute the amount has been recognized. It is not often the case in matters of business policy and prudence such as this that the courts lead where business men and some professional men are reluctant to follow. Contingent Depreciation A third factor in depreciation is given in the chart on page 121 as contingent. The term would seem to indicate on the face of things that it is not a factor of sufficient definiteness and certainty to make possible its prevision and therefore the calculation of its effect. Hence it might seem that provision could be made for it only by means of a general reserve. In many individual cases and as to its application as a universally operative factor in the same sense that are use and wear and tear, the position is undoubtedly well taken. The term contingent, as here used, is meant to cover not only things which have happened and _may_ happen again, but also things which in given localities and under known or knowable conditions are more or less inevitable. Hence while not found present in all cases, where conditions are favorable to the happening of any of the contingencies, from the standpoint of prudence and an equitable distribution of the burden of costs, provision should be made for them as one of the items comprising depreciation. Contingent depreciation may comprise three classes of contingencies, viz., (1) accidents, (2) diseases, and (3) diminution in supply. _Accidents._ With regard to the first class, M. E. Cooley, in the Milwaukee Three-cent Fare Case, says: “An engine or a boiler may be wrecked and with it other machinery. This might, and probably would, involve a considerable expense for repairs or replacement, besides possibly crippling the plant in part. Cars may collide or a car may drop through a bridge. A bridge itself may fall or be carried away by floods. A storm, as a cyclone, may work havoc, entailing costs in excess of those proper to be charged to ordinary maintenance of property.” Accidents may happen either as a result of negligence or as a so-called “act of God,” i.e., the elements, or a hidden defect in the structure. With regard to depreciation from accidents it may be quoted, “There is always a certain amount of loss by accident which seems to be inseparable from the business. Usually it can be counted on in advance, and no amount of care and precaution will entirely eliminate it.”[24] The Railway Library for 1910 says that of 899 railroad accidents the various causes were: Malicious acts 30 accidents Elements 104 ” Structural defects 117 ” Various forms of negligence 648 ” [24] Spring Valley Water Co. v. San Francisco, 165 Fed. Rep. 703. In a large concern where past experience may serve as a guide to the future, depreciation of this sort can be rather accurately estimated. In the case of the rolling stock of a railroad, statistics make available the yearly loss due to accidents from whatever cause. It is argued that such losses are fairly uniform from year to year in a large system of that sort, and each year’s operation carries the burden simply by charging all repairs incident thereto against the revenues of that period. This is, of course, true in the main and may give sufficiently accurate results. The same treatment may also be applied to replacements, and if the units are sufficiently small in value in comparison with their number, practically no inequity as between periods will result. However, the Interstate Commerce Commission has ordered that depreciation reserves shall be set up for the proper handling of such accidents and this seems the better method. Statistics are available as to how frequently explosions in powder factories are apt to occur and the losses due to them, so that a manager can calculate the provision to be made on that account. Those are simply the risks of the particular business, and wherever it is known that they are applicable to any kind or group of equipment or other assets, certainly the current operations should bear their share. After all, depreciation charges due to any causes are much of the nature of insurance which has to be carried by the enterprise itself because the risks have not yet been reduced to an insurable basis. Much as a proprietor may dislike to carry his own depreciation insurance, he is compelled to. In connection with accidents as a part of the depreciation charge, it should be noted that the product should not be charged twice for this item. If regular insurance is carried for fire, flood, tornado, earthquake, and the like, certainly those elements should be omitted from the insurance risk carried as depreciation by the concern itself. _Disease._ Under certain conditions as to climate and local environment, the ravages of disease must be reckoned with. Diseases are caused by: