Theoretical depreciation, a menace to the public and the investor;

              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.