Chapter IX.. The Standardization of Depreciation Rates

The Standardization of Depreciation Rates

The determination of the rate of depreciation of a given asset is essentially an engineering problem. But as the accounting for depreciation is dependent on the rate, and the records of the accounting department must furnish much of the information for estimating the rate, the whole problem of fixing depreciation rates will be considered under the one head. Much study and effort to reduce all the conditions under which assets depreciate to a common basis and so to a definitely stated rate for each set of conditions, have, so far, come to naught and all qualified experts say without reserve that the rate of depreciation is an individual problem. It is to be hoped that a further gathering of statistics as to expectations of life of different assets under varying conditions will ultimately furnish tabulations, corresponding to insurance tables, according to which under known and expected conditions a fairly accurate rate of depreciation for a particular asset may be made. Unlike insurance rates, however, the depreciation rate once established will not necessarily remain constant, but must be subject to a periodic revision in the light of new data and conditions.

Effect of Local Conditions

Many factors enter into the rate of depreciation. They may be classed roughly as “stable or normal” factors and “contingent” factors. It should be constantly borne in mind that in the present state of the actuarial development of the subject, general rates, i.e., rates which will apply without readjustment, cannot be determined. For the determination of individual rates local conditions are always the controlling factor. An illustration in point is given by Henry Floy, showing the varying rates used by thirty-one different concerns for the depreciation of their rolling stock equipment. The methods vary in almost every case, comprising annual charges of an arbitrary amount, per cent of the original cost, cents per car mile, arbitrary deductions from income irregularly applied, per cent of gross earnings, per cent of present estimated values. Reduced to a common basis, the per cent methods show a range of expected life varying between ten and one hundred years. While it is improbable that had the determination of the depreciation rate for the different concerns been in the hands of the same expert, there would have resulted these bewildering variations in method, still it does bring out in strong relief the fact, well recognized by experts but so often lost sight of by those unacquainted with the technical phases of the problem, that local conditions are a controlling factor; and that until local conditions can be somewhat standardized there is no hope of establishing rates of depreciation which will be of general application.

In “Value for Rate-Making,” pp. 255-256.

Factors in Determining Depreciation Rate

In the determination of rates the factors to be taken into account are:

1. Normal operating conditions. 2. Normal load or normal intensity of operation. 3. Normal repairs policy. 4. Normal climatic conditions.

These constitute the most important stable or normal factors. Among the contingent elements, the most important are:

5. Probable misuse and neglect brought about by the demands of the trade, resulting in a change in the factor of normal intensity. 6. Probable change in ownership and consequent change in policy. 7. Probable change in the requirements of the market, necessitating an adaptation of the equipment to uses for which it was not originally intended.

At the time of installation the rate of depreciation must be based only on the normal factors—things which can with reasonable certainty be counted on. At intermediate periods in the life of the asset, a physical inspection should be made to compare the actual depreciation of the property with the estimated. If, then, it is found that any contingent factors have become real or reached the point of reasonable expectancy, these provide the basis for an adjustment of the rate for the remaining life-term of the asset.

Basis of Normal Rate

With regard to the normal rate, the following items demand first consideration:

“1. Exterior or movable apparatus

(a) Abuse (b) Neglect (c) Temperatures (d) Oxidation (e) Irregular shocks in use, such as starting or braking, also road or rail defects

2. Installed operating and generating machinery

(a) Reversals, increased by rapidity and aggravated by shock (b) Irregular loads or service, aggravated by speedand sudden character (c) Excessive usage, resulting in increase of temperature of parts

3. Fixed equipment including boilers and piping

(a) Excessive and irregular strains (b) Interior causes of decay (c) Chemical action

—all these being of greater or less effect, according to the time of daily usage and lack of periods of rest.”

R. P. Bolton in “Power for Profit.”

Policies as to Repairs

Without doubt the most important single factor in the determination of the depreciation rate is the normal policy as to repairs and maintenance. Physical deterioration is constantly at work. If this is counteracted by a liberal maintenance policy, not only is more efficient service secured but a longer service life is thereby insured. As soon as repairs are needed, although the efficiency of the asset may not be immediately impaired, the rate of deterioration is much accelerated unless the condition is corrected. Deterioration takes place day by day, but repairs obviously cannot be made at such short intervals—both because of the difficulty of detection and also because such a policy would not be economically practical. Every concern must consider its own peculiar problems and determine from these what shall constitute its normal repairs policy, and so far as possible this should be adhered to. The charges for repairs are bound to be of a more or less irregular character. Their handling is discussed on page 147.

Regardless of what the established policy as to repairs may be, conditions are sure to arise which make strict adherence to it impossible. There may occasionally be lack of funds at the time repairs are customarily attended to; it may be impossible to get the expert labor needed or the parts to replace worn-out units; or, and of oftenest occurrence, the need of repairs may coincide with a period of intense activity when the plant is being worked to its limit and in consequence there is no opportunity for making repairs. It is clear that rates based on one shift and the normal use of equipment during eight hours would be inadequate for three shifts and twenty-four hours of use; for in addition to a threefold intensity of operation this makes impossible adherence to the normal repairs policy based on an eight-hour schedule.

Depreciation Rate an Engineering Problem

From the above discussion it is apparent that the determination of rates is essentially an engineering problem. The accountant, however, needs a knowledge of the fundamental considerations and requirements of fixing depreciation rates and an appreciation of the difficulties of the problem. As Henry Floy says: “What engineer is able to foretell the misuse and neglect or care and high degree of maintenance that any given apparatus or ... property as a whole will receive, even during the next five or ten years, with vicissitudes of climate, load conditions, changes of management, and requirements of the public?” On the other hand, in the opinion of another prominent engineer, “Consideration of these matters (misuse, neglect, etc.) may eventually form the basis for a systematic appraisal of the probabilities of life, or average of the risks, which would provide a method for the insurance of the life of machinery.”

In “Value for Rate-Making.”

The author does not attempt to discuss the relative merits of the two contentions other than to point out the fact that engineers are not discouraged in spite of the many contingencies and uncertainties inherent in the problem. They are constantly gathering data from which conclusions as to rates are being formed, the use of which is being compelled by regulating bodies. It is possible that the problem will ultimately be worked out on some kind of an insurance basis.

Attitude of Regulatory Bodies

At the present time the attitude of most regulatory bodies—public service boards, federal commissions, and tax officials—is well expressed by a regulation of the Public Utility Commission of New Jersey which says that, “Until otherwise prescribed, the amount estimated to be necessary to cover such wear and tear and obsolescence and inadequacy as have accrued during any month shall be based on a rule to be determined by the accounting corporation; such rule may be derived from a consideration of the said corporation’s history and experience. A general statement of the rule in use by each company, together with the general information upon which it is based, is to be filed with the Board of Public Utility Commissioners.” The trend at the present time is towards a more thorough supervision of depreciation rates on the part of many public service boards, and the future will undoubtedly see interesting developments.

Methods of Handling Repairs

Three distinct practices are met with in handling repairs and renewals on the books. The most general method is dictated by ease of application and rests on the theory of averages, viz.: that the amount of repairs annually recurring for depreciating equipment in all degrees of deterioration and all stages of decay and age is a fairly constant figure which secures an equitable distribution over the product of the different years. The larger the plant and the greater the variety of the equipment used, the more nearly does this work out as expected.

Further consideration will be given to this point in the discussion in