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102 HASKINS & SELLS November "Theoretical Depreciation, a Menace to the Public and the Investor" Discussed by H . B. CAVANAUGH, of the Cleveland Office THE foregoing is the title of an article written by Mr. George N . Webster, an attorney of New York City, and published in "The Annalist" of July 21, 1919. The article deals with depreciation as used in connection with valuation of public service corporations for rate making purposes, and in general as being an economic rather than an accounting problem. While it would be necessary to read the article to fully understand its scope, it is hoped that the reader will be able to gather a fair idea from the following excerpts taken from sections of the article as printed: The most serious menace to which investors in the securities of public service corporations are exposed today results from their failure to comprehend and to combat unsound and destructive theories of valuation, which, when employed in the determination of the value of their properties for purposes of rate regulation, operate to confiscate a very substantial percentage of their investment. . . . The advocates of the depreciation theory would state the formula in this way: A unit of equipment costs 310,000.00; it had a life expectancy when installed of thirty years; ten years have elapsed; ten years is one-third of thirty years; one-third of $10,000.00 is 33,333.33; this deducted from the "cost" leaves the "present value" of the unit of equipment as $6,666.67. . There are many engineers of honest intention who pretend, or even think, they have knowledge of this subject, who while competent in the ordinary branches of construction engineering are utterly lacking in a real and fundamental understanding of this dangerous fallacy of "theoretical depreciation." The problem is, in fact, not one of engineering nor is it one that engineering training fits an engineer to properly understand. The same may be said of the accountant and his training. The subject is one primarily of applied economics and must be studied from the standpoint of the mutual economic interests of the consumer and the investor. . . . When the services of a professional depreciator are retained by a municipality, it is in order that by the exploitation of this theory of depreciation a reduction in the rates may be effected, not because the service has in any way deteriorated, but solely because the plant and equipment employed in rendering it, while in every way was as good as new and functioning just exactly as well and possibly infinitely better than when it was new, is De Facto not BRAND NEW. . . . The Modus Operandi of the professional depreciator, as stated, is to guess at what he terms the "life expectancy" of the plant and equipment in service and having computed the percentage of "expired life" he uses the same percentage to compute "expired value." He does not like to say "expired investment." . .. . He sticks to value, because he knows that value is an elusive and ambiguous term and that there is less likelihood of someone pinning him down to admitting that he does not know what it means, than there is of someone pinning him down to an admission that an investment can not expire. He knows nothing about accounts and less about engineering. . . . The consideration of age enters no more into the question of rates of a public service company, which is able and does render the service it was organized to render, than does the age of a taxicab, or of its driver, or of the clothes he wears, enter into the question of the fare. . . . Even where no "depreciation reserve" whatever has been created, the professional depreciators argue that one should have been accumulated and that failure to do so is evidence that the property has been milked through excessive dividends. . . . For a concrete example, consider the history of the average gas company. It is organized, capital raised, a plant constructed, the latest and best types of apparatus installed therein, and mains, services and meters installed in the district to be served. . They know that there will be wear and tear which will involve repairs which as they are made, will and should constitute a part of the current cost of the service. They know that such cost, as a matter of practice, is not, and should not be collected in advance, for the obvious reason that the earnings for each year should bear the burden of the maintenance expenditures for each year, otherwise the statement of results of a year's operations, in so far as the revenue and expenses are concerned, is distorted. . . . They take no heed whatever of future obsolescence or inadequacy for two reasons: first, because not being clairvoyants they cannot foresee when, if ever, obsolescence or inadequacy in respect of any unit of plant or equipment is going to occur, and, second, because being business men, they know that when, if ever, obsolescence or inadequacy does occur, it will result from an advance in the art or a development of the business which should and will, itself, take care of the loss involved in the displacement of the retired unit of plant or equipment. . . . Investors as a class engage in public service enterprises because they deem them to be not only profitable but permanent. Money put into railroad construction, for example, can never be withdrawn. To unmake a railroad would restore no amount of cash to those who constructed it. It would require as much money in the unmaking as in the making if not more. Therefore, were it not for the permanent character of the public service business there would be no public service, because no investor would embark in it as a business. . . . The cost of rendering the service includes, of course, the cost of maintaining the plant and equipment in efficient operating condition by repairs and renewals, as well as the cost of amortizing the investment in plant and equipment displaced from time to time in order to effect improvements and economies made possible by the advance in the art of rendering the particular service in which he is engaged. . . . The amount which he. collects in excess of the cost of rendering the service, is his profit, to be disposed of as he may see fit: That is to say, he may pay it out in dividends or carry it in a surplus account or segregate it and carry it in a reserve account, or he may do all three of these things.
Object Description
Title |
Theoretical depreciation, a menace to the public and the investor |
Author |
Cavanugh, Harry B. |
Contributor |
Webster, George N. |
Subject |
Depreciation |
Office/Department |
Haskins & Sells. Cleveland Office |
Citation |
Haskins & Sells Bulletin, Vol. 03, no. 11 (1920 November 15), p. 102-105 |
Date-Issued | 1920 |
Source | Originally published by: Haskins & Sells |
Type | Text |
Collection | Deloitte Digital Collection |
Digital Publisher | University of Mississippi Libraries. Accounting Collection |
Date-Digitally Created | 2009 |
Identifier | HS Bulletin 3-p102 |