CHAPTER XI

RECORDING DEPRECIATION ON THE BOOKS Methods Commonly Employed Two methods of booking depreciation in the ledger are commonly employed. The periodic adjusting entry on account of depreciation has as its basic purpose the separation of the mixed account under asset title into its two elements—the one to show the expense element, the other to set up the true valuation of the asset. The expense element is set up under the one title “Depreciation” for all the assets. The deduction from the values as shown in the unadjusted asset account may be made either by credit entry direct to the asset account or by entry to a separate “Depreciation Reserve” account, each one of these reserves distinguished by the name of the asset to which it applies. The latter method is preferred because thus the asset account at any time shows the original cost of the property—information of value for many purposes and worth the effort needed to maintain it distinct from other items. Under this method every wasting asset account is immediately followed by its particular depreciation reserve account, called its “valuation” account. The depreciation reserve is as much a part of the record of the asset as is the asset account itself. The two accounts are complementary, neither giving reliable information without the other. The reserve account is thus always and only a balance sheet account. The above statement indicates the most satisfactory method of handling the various depreciation reserve accounts on the balance sheet. Although appearing on the credit side of the ledger, they are in no sense liability accounts, being interpreted always as credits to the asset account, held in suspense, as it were, in the reserve account, pending full determination of their accuracy, which governs their ultimate disposition. Thus, on the balance sheet, either only the net present value of the asset should be shown, or preferably its original cost with its value extended short, its depreciation reserve deducted, and the present value, thus determined, full-extended. Further information of some value is given if besides the amount of the reserve the rate of depreciation is shown, though this is not often done. Occasionally an entirely incorrect showing, from the viewpoint of strict form, is seen when not only are the depreciation reserves—usually in one item—shown on the right side of the balance sheet but are set up in the Net Worth section, seemingly as a part of the surplus or other true profit reserves. This practice cannot be justified on any ground except that the sheet is kept in balance—a consideration which is far removed from real essentials. Renewals and Replacements _First Method._ As to the handling of the reserve at the time of renewal of parts and replacement of the entire asset, here also two methods are met. Under the one, the original cost of the part (or whole) retired is transferred from the asset account, its salvage value as defined above being carried to a Salvage account, and the cost less salvage portion being charged to the reserve account of the asset. This clears the asset account of all capital charges on account of the part (or whole) retired. The new part (or whole) replacing it is now charged to the asset account which then represents true cost of the new asset. If it is a whole which is replaced, theoretically the charging of it against the reserve should just clear that account of all values. Practically the preliminary estimate or forecast of the amount and time of depreciation never coincides exactly with the fact of depreciation. A credit balance in the reserve indicates an overallowance for depreciation and is an item of true reserved profits, i.e., surplus; whereas a debit balance indicates an insufficient allowance and is an expense item chargeable against surplus and not _current_ profits. This matter is treated at greater length on page 205. When the whole asset is replaced, the depreciation reserve should always be cleared of any remaining balance, as indicated above, so that the new asset and its depreciation allowance may be handled and watched unobscured by the record of any inherited sins or virtues from the past. _Second Method._ The other method of handling the reserve at the time of replacement requires a comparison of the cost of the displaced asset and the cost of the new asset. The old asset account is allowed to stand untouched, but any betterment, i.e., excess of reproduction cost over original cost, is charged to it so that the asset account may show cost of the new asset. This cost, except for its betterment portion, if any, is now charged against the reserve. Both methods thus accomplish the same purpose, but the first is more direct and simpler of operation. It may be interesting to note that, in early instructions to railway accounting officers, the Interstate Commerce Commission prescribed the second method, which emphasizes the betterment feature. The present regulation is in accord with the first method. Occasionally one finds a practice which, though based on the second method, differs in that no determination of betterment values is made, the original asset values remaining undisturbed and the entire reproduction cost being charged against the reserve account. This practice, of course, is due to a lack of understanding of the nature and purpose of the depreciation charge and its offsetting reserve, and is counter to correct principles. There is, however, seeming judicial support for it in cases of the valuation of utility properties for rate purposes. The problem is discussed in full on page 202. The entries on the general books thus present no difficulties. Subsidiary Records Subsidiary records should usually be kept to show the detail of the group asset accounts carried on the general ledger. Not only is this necessary to maintain an adequate check on the inventory of the group asset and control over it, but without a detailed record of items it is impossible to keep careful watch over the operation of the forces of decay and depreciation and, therefore, equally impossible to build up reliable experience data concerning each group of assets. The amount of detail necessary in the record of the plant assets is dependent upon the information desired and capable of being obtained within a limit of cost low enough to make it worth the cost. This is a matter of policy which the management must determine. It may be desirable to carry the records in much greater detail for a period than would be justifiable as a permanent policy. It may be worth while to make more or less frequent studies of particular groups of assets in order to check up the effect of the depreciation rates. As is pointed out elsewhere, while the preliminary estimate of expected life, and determination therefrom of the depreciation rate, are of great importance and the utmost skill and judgment possible should be employed, only a policy of everlasting vigilance and readjustment, in the light of new data available with the increasing age of the asset, will bring satisfactory results. To predetermine a rate and then to expect it without supervision to work out to a successful conclusion is, to say the least, foolish. Only by means of a complete record of life histories can a mass of reliable data be built up which can be made to serve as a guide for the future. The depreciation problem is an individual problem and must, from the nature of things, remain so to a marked degree. Until conditions under which the lives of assets are to be lived become more or less standardized, or so long as each concern must carry its own depreciation insurance, standard rates of depreciation will not have a controlling significance. Grouping and Classification of Plant Assets From what has been said it is evident that the assets of a plant must be divided into groups for the sake of simplicity and convenience in keeping record of them. The basis of grouping should be physical similarity, process, or product. Thus, all tram cars might be carried in a group, as also all machines doing the same work or process. Groups of machines performing different processes on the same product could well be treated as a depreciation unit, and likewise all buildings used for the same purpose, if of a similar type of construction. If the latter are of different types it might be desirable to keep separate records. As stated above, the information desired must govern the groups under which record of behavior and performance are kept. A numerical or an alphabetic numeric system of classification and identification is advantageous. Each machine, piece of equipment, or other asset should be marked or tagged when installed so that any particular piece of equipment can be identified at any time. The tag should carry date of installation and the name of the maker or vendor, as well as its own identification number. By the use of a combined alphabetical and decimal numerical system, almost any possible grouping can be made according to main and auxiliary groups, processes, or products. Form of Plant Ledger The form of the plant register or ledger need not be elaborate. Its main subdivisions should correspond with the subdivisions of plant and equipment carried on the general ledger. Thus, if we find therein accounts with buildings (factory, store, office, etc.), machinery, furniture and fixtures for factory, store, and office, delivery equipment, etc., subsidiary records should show corresponding subdivisions. It should be a matter of fixed policy to require a periodic proof of these subsidiary records against their respective controlling accounts on the general ledger. Only thus can the inclusion of all items in both records be made certain. The control established must cover both the items of the assets record—the original cost as shown by the asset account—and the accumulated depreciation as shown by the reserve account. Asset Record Aside from the title and classification and identification number, the plant register should provide a record of the asset under the heads of: