5. Periodic appraisal value.

On the form shown below, provision is made for adjustment of the original estimate of depreciation. Where there is a realizable scrap value, additional columns to show scrap value and total depreciation to be written off should be provided. The form shown would have to be adapted to the method of depreciation decided upon as applicable to a particular asset. Thus, if working hours or service output are the basis, provision should be made to show the basis of calculation of each period’s depreciation burden. The following form is well adapted to make record of the asset under the straight line method of depreciation. [Illustration: From “Principles of Depreciation” by Earl A. Saliers. _Plant Ledger (showing adjustment of value)_] Periodic Revision of Rates In Chapter VIII where the problems in connection with depreciation rates were discussed, a periodic testing of the effects of the particular rate employed was laid down as an essential for the application of any rate. The determination of the rate in the first place is a problem requiring expert knowledge and the most careful consideration of many factors. Hardly less important, however, for the successful operation of any depreciation scheme is the attention given to the manner of its operation and a modification and readjustment of rates to bring the theoretical expectation of the wasting of the asset into accord with its actual wasting to date. At the beginning, when the asset is first installed the depreciation rate must be based, so far as this particular asset is concerned, entirely on contingencies. None of its life has been lived; none of its actions and behavior have yet become a matter of record. What it is apt to do can be forecast only by a study of its ancestors—heredity as modified by a reasonable expectation of change due to different environment. However, at the end of five years, say, there is available a record of service and behavior in the light of which not only can the accuracy of the forecast be judged, but also a more reliable forecast for the remainder of its service life can be made. Frequency of Revision of Rates Because of the conditions stated above, a periodic testing of rates should be made. How frequently this should be done depends largely on local conditions. Certainly sufficient time should be allowed to pass to secure a really worthwhile test. What constitutes a sufficient time depends largely on the expected length of life. Long-lived assets obviously need not be tested so frequently as short-lived assets; and the periods should be shortened when the asset has been serving under supernormal conditions; the intensity of its life would be a controlling factor. It is usually stated that this testing of rates and conditions should be made at least every five years in the form of an appraisal. In the physical appraisal care should be used not to allow present market prices to enter into it, else the element of fluctuation may easily be brought in to nullify or exaggerate the real results of depreciation. Test of Condition Per Cent At the time of reappraisal the estimated condition per cent or the expectancy as to remaining service life are the points most to be considered. C. E. Grunsky has made an interesting contribution to the study of expectancy—theoretical, it is true, in the sense that it is based on assumed hypotheses, but nevertheless of value as calling attention to a phase of the subject that presents large possibilities. He takes 10,000 similar articles, all of probable life-terms of 10 years, and all simultaneously installed. Assuming that of these 10,000, 100 will fail or go out of service at the end of the first year, 200 at the end of the second year, that the largest numbers will fail in the years just before and just after the expected life-term of 10 years, and from then on, that there will be a gradual decrease in the number of failures until the 20th year, beyond which time (double the estimated life-period) none will remain in service—the following table is shown, which gives in the last column at the right the life expectancy of all remaining articles as at the beginning of a given year. It will thus be seen that an article which has survived its 5th year, has at the beginning of its 6th an expectancy, not of 5 years but of 6.12 years; an article which has lived its allotted 10 years has an expectancy of 3.67 years; and so on. Certainly Mr. Grunsky’s study, if it serves no other purpose, at least draws attention to possible lines of development and, read in connection with facts as to the known length of life of many assets which have outlived their expected terms, it draws strong attention to the need of very careful use of any so-called mortality tables. These life history tables for assets are similar to the mortality tables used by life insurance companies. TABLE OF EXPECTANCY[37] The probable life of each article is 10 years or periods. For terms other than 10 years, each year in the table may be regarded as a period equal to one-tenth of the probable life-term. (Based on the special hypothesis of failures as explained in the text) ========+==========================================+=============== | FOR 10,000 ARTICLES | SINGLE ARTICLE +----------+------------------+------------+--------------- Year or | | Remaining Number | Remaining | Period | Number | of Articles at | Service at | Expectancy at | of | Beginning of | Beginning | Beginning of | Failures | Year | of Year | Year or Period --------+----------+------------------+------------+--------------- 1 | 100 | 10,000 | 100,000 | 10.00 2 | 200 | 9,900 | 90,000 | 9.00 3 | 300 | 9,700 | 80,100 | 8.27 4 | 400 | 9,400 | 70,400 | 7.46 5 | 500 | 9,000 | 61,000 | 6.77 6 | 600 | 8,500 | 52,000 | 6.12 7 | 700 | 7,900 | 43,500 | 5.51 8 | 800 | 7,200 | 35,600 | 4.95 9 | 900 | 6,400 | 28,400 | 4.44 10 | 1,000 | 5,500 | 22,000 | 4.00 11 | 900 | 4,500 | 16,500 | 3.67 12 | 800 | 3,600 | 12,000 | 3.33 13 | 700 | 2,800 | 8,400 | 3.00 14 | 600 | 2,100 | 5,600 | 2.67 15 | 500 | 1,500 | 3,500 | 2.33 16 | 400 | 1,000 | 2,000 | 2.00 17 | 300 | 600 | 1,000 | 1.67 18 | 200 | 300 | 400 | 1.33 19 | 100 | 100 | 100 | 1.00 20 | 0 | 0 | 0 | 0 --------+----------+------------------+------------+--------------- [37] From “Valuation, Depreciation and the Rate-Base,” by C. E. Grunsky. Composite and Group Rates In the practical application of the depreciation rate in a large plant, every separate piece of property is not, of course, considered by itself. The plant is divided into groups of similar assets, determined roughly on the basis of life expectancy, conditions of service, etc. Using these groups it is possible to find the rate of composite depreciation—a figure which serves as a check over the group depreciation. This is also sometimes called the “mean life” of the plant. It is determined by two methods—one called the direct, the other the dollar-year method. Assuming groups of assets of varying life lengths and costs, the following examples show the manner of estimating the amount of depreciation for the whole plant and also composite life; that is, the mean average life of the individual assets when viewed not as units but as a composite whole: MEAN LIFE DIRECT METHOD ======+=========+================+==============+============= Group | Life | Value | Rate | Amount of | in | to be | of | Periodic | Periods | Depreciated[38]| Depreciation | Depreciation ------+---------+----------------+--------------+------------- A | 5 | $100,000 | 20 | $20,000 B | 10 | 75,000 | 10 | 7,500 C | 15 | 60,000 | 6⅔ | 4,000 D | 20 | 120,000 | 5 | 6,000 | | -------- | | -------- | | $355,000 | | $37,500 ------+---------+----------------+--------------+------------- [38] That is, cost less salvage. Mean life is $355,000 ÷ $37,500, or 9⁷/₁₅ periods. Under the dollar-year method, the invested values are weighted by the length of their investment term and thus all investments are reduced to the common basis of one dollar for one year: MEAN LIFE DOLLAR-YEAR (OR WEIGHTED RATIO) METHOD =====+====+===========+=============+================+============ | | Values |Turnover Rate|Total Investment| Group|Life| to be | in Longest | During Longest |Dollar-Years | |Depreciated| Life-Period | Life-Period | (a) |(b) | (c) | (d)[39] | (e) | (f)[40] -----+----+-----------+-------------+----------------+------------ A | 5 | $100,000 | 4 | $400,000 | $2,000,000 B | 10 | 75,000 | 2 | 150,000 | 1,500,000 C | 15 | 60,000 | 1⅓ | 80,000 | 1,200,000 D | 20 | 120,000 | 1 | 120,000 | 2,400,000 | | -------- | | -------- | ---------- | | $355,000 | | $750,000 | $7,100,000 -----+----+-----------+-------------+----------------+------------- [39] That is, the number of times renewal of the asset will be required during the longest life-period of any of the assets. [40] Dollar-years, column (f), is the product of the total invested values as shown in column (e), and the life of each group as shown by column (b). Thus, $400,000 invested for 5 years is the equivalent of $2,000,000 invested for 1 year. Column (f) ÷ column (e), (7,100,000 ÷ 750,000 = 9⁷/₁₅) gives the mean life. Column (e) ÷ the longest life-period, 20 years, (750,000 ÷ 20 = 37,500) gives an annual charge for the whole plant. What is known as “mean” age or plant expectancy as to remaining life may be found similarly. Assume a physical appraisal made after 12 years’ life of the above assets: MEAN AGE (LIFE EXPECTANCY) DIRECT METHOD =====+====+==============+=========+============+=============== | | Unexpired or |Condition|Values to be| Values Already Group|Life|Remainder Life| % |Depreciated | Depreciated (a) |(b) | (c) | (d)[41] | (e) | (f) -----+----+--------------+---------+------------+--------------- A | 5 | 3 | 60 | $100,000 | $40,000 B | 10 | 8 | 80 | 75,000 | 15,000 C | 15 | 3 | 20 | 60,000 | 48,000 D | 20 | 8 | 40 | 120,000 | 72,000 | | | | -------- | -------- | | | | $355,000 | $175,000 -----+----+--------------+---------+------------+--------------- [41] (d) = (c) ÷ (b). Group A assets, having been twice renewed, would be in 60% condition; Group B, 80%; Group C, 20%; and Group D, 40%. Column (f) ÷ column (e), (175,000 ÷ 355,000 = 49²¹/₇₁%) gives the per cent of composite depreciation already taken effect. The mean life, as determined above, multiplied by per cent of composite depreciation gives the mean age or portion of the mean life already lived (9⁷/₁₅ × 49²¹/₇₁% = 4⅔). The figure of mean or composite life may serve two purposes. First, it forms the basis for comparison with other similar plants and is about the only fair basis for comparison. Second, it gives the basis for estimating the amount of annual depreciation of the plant as a whole. This statement does not mean that individual depreciation reserves are not to be carried for each group of assets and those charged with the value of the asset as soon as it is discarded and renewed. But the use of the estimated mean or composite life figure does give a control over the amounts which should always be found in the individual group reserve accounts, i.e., at any given time the sum of the individual reserve account balances should be approximately equal to the amount as shown by the reserve when calculated on the mean life basis. The Reserve as an Index of Financial Condition The statement is often made that a balance sheet showing depreciation reserves points to a conservative policy in the treatment of plant properties. Usually such a balance sheet affords little or no basis for expressing a judgment as to conservatism or the lack of it. All that it does show is that recognition is made of the _fact_ of depreciation. As to its _adequacy_ or _inadequacy_, a knowledge of other factors is necessary. _Fluctuating Reserve._ According to successive balance sheets a reserve may vary little from year to year, or it may show considerable increase or decrease, and any of these conditions may be entirely normal and express adequacy of reserve requirements. In the first case, stability of the reserve may result because the asset is short-lived and hence is more or less frequently replaced; or different units of the property may have been installed at somewhat regular intervals so that retirements from service are also somewhat regular. Under either supposition, the charges against the reserve for the units displaced would just about keep pace with the regular credits to reserve for replacement purposes. In other words, that condition of the reserve for that class of asset is the normal condition—except perhaps in the case of a rapidly expanding plant, or other conditions not counted as normal when the reserve requirements were put into operation—and any other condition should lead to inquiry and investigation. _Increasing Reserve._ In the second case where the reserve is showing a considerable increase from year to year, that also may be a normal condition. Long-lived assets are seldom replaced with any degree of regularity in the annual charge against the reserve, except in the case of very large plants where the number of such assets is correspondingly large in proportion to their size. Here more or less regular installations may take place as a result of an expanding business, covering a period of approximately the same length as that of the life of the asset. So here, too, any other than a regularly increasing reserve must incite inquiry. _Decreasing Reserve._ As to the third case, that of a somewhat regularly decreasing reserve, the condition is not usually normal but may occasionally be met in a plant where one type of equipment is being retired and not replaced, due perhaps to a changing line of activity; as when, for instance, a stock furniture manufacturer works gradually into the exclusive manufacture of automobile and carriage bodies. Some types of equipment will thus be gradually retired and their reserves will constantly diminish, their place being taken by other reserves covering the new type of equipment. However, this condition of decreasing reserves, while entirely normal under certain circumstances, being unusual, should always receive careful investigation. It is here that mean life and mean age or composite plant depreciation are of assistance in forming a judgment as to the general adequacy of reserves. The Reserve in Relation to Expanding Plant In the case of a plant the development of which is stationary, the problem of judging the adequacy of the reserves is simple in comparison with a plant which is expanding, resulting not only in the installation of more of the same kind of equipment but also of equipment of other kinds. A disturbing element is thus introduced and careful oversight of the depreciation policy must be exercised. In all cases, intelligent reading of the reserve and its sufficiency are internal problems based on intimate knowledge of conditions. Lacking this knowledge no true judgment can be made. The character of the asset, number of units in use, dates of installation, a comparison of the assumed conditions at date of installation with the actual conditions of the present—all are factors to be taken into account. Reserve as Related to Efficiency The general relation of efficiency to depreciation has already been discussed. As to whether the condition of the reserve is any index of the efficiency of the service rendered by the plant unit, attention is briefly directed to a misinterpretation of individual reserves. Experts state that many types of equipment cannot deteriorate actually more than a fixed per cent of their cost and continue to give efficient service. If, say, 30% is the limit in the case of one type, this does not, of course, indicate that, as soon as the depreciation reserve shows an amount equal to 30% of the cost, the approach of inefficient operation and the time of discard are at hand. It must be borne in mind that the reserve is a device based on financial considerations and, if properly calculated and handled, no asset should be ready for retirement until its reserve approaches in amount the value at which the asset is carried in its account. Nor is the point of approaching inefficiency shown until that condition of the reserve is found. Reserve not Based on Cost of Replacement The question is sometimes raised as to whether reserve requirements should be based on original cost or cost of replacement new. The question usually reveals a lack of understanding both of the purpose of the depreciation charge and the means of financing depreciation. It is usually said that the reserves carried on the books are for the purpose of providing the means of financing the replacement. It is not the purpose here to go into the question of original cost versus cost of reproduction new, either as a basis for valuation of public utility properties or from the viewpoint as to where the incidence of the burden of replacement properly should rest—whether on the users of the service given by the asset to be replaced or on those using the new asset. In the private enterprise where the rights of the public are not so apparent, under present-day tenets of political and economic philosophy, only internal policies and purposes to be accomplished need be considered. As stated above, the basic purpose of the creation of the reserve is to burden the product with depreciation charge as a real part of the cost of production. If we are concerned with real and actual costs of production, by no stretch of the imagination can replacement cost—what it might cost to replace the asset at some more or less distant time—enter into the question. It might, with equal obscurity of logic, be said that, because the labor cost is bound to be higher 10 years from now than at present, in order to get the true _present_ cost of the product the estimated future labor cost should be taken in place of the actual present cost. The Financing of Replacements If one purpose of the depreciation reserve is that of financing depreciation, this can mean only that the reserve must insure provision being made so that the capital invested will not be lessened or encroached upon by the wasting of the assets in which it is invested. It is no necessary or proper purpose of the reserve to provide for increasing the invested capital. _Financing_ the _replacement_ of the retired asset is a separate financial problem and only concerns accountancy, so far as the records may reflect that policy. The reserve, in itself, does not furnish the means of financing any part of replacement, as was fully shown above. If the new asset is expected to cost more than the old, certainly business prudence would dictate provision for the added cost as well as ready funds of an amount equal to the original cost. The actual capital provided originally need be sufficient only for the time being; to provide more than that, if remaining idle, would be folly. If there is evidence of expansion, or if it is recognized that more will be needed—due to change in markets—for replacement purposes than was originally needed at the inception of the enterprise, provision must be made therefor. _Methods of Financing Replacements._ In the financing of replacements, three courses are open: