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Depreciation—How Should it be Charged ?

28th February 1907
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Page 23, 28th February 1907 — Depreciation—How Should it be Charged ?
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Which of the following most accurately describes the problem?

By Douglas Mackenzie.

There are many eeopk by whom the term depreciation is /never understood. It appears CO them, merely, as an excuse of their auditors to prove that they have made a loss when they think they should have shown a profit. There are others, who insist that depreciation should, always, be calculated, but who have only a vague idea, if any, as to what it means. Depreciation, put briefly, expresses the dif-, ference between the price at which an article was bought, and that for which it will, at a particular time, sell. The former price is known, and appears in the books at the time of the transaction, whilst, if the same article is, actually, sold, the realised difference on its re-sale is, also, known. If the article is, however, still in stock, either as something for re-sale, or as working plant, it is necessary, at the annual audit, to get some idea of its real value.

There are different factors which mav affect present value, and all of these must be considered. A horse will he so much older, and so much nearer to the end of its useful life. Most articles in use will have become second-hand, and there is, as a general rule, a big drop in value from new to secondhand. The accountant wants to get at the loss due to any or all of several factors, and to do so in the simplest manner. He can, usually, ascertain the present value of secarities, and so fix the depreciation definitely; and, in sonic cases, lie can employ an expert valuer to go through stocks, and to put a figure on each article. Ile has, more usually, to fail back on an approximation, and to write off so much per cent. to represent depreciation. It will, therefore, he understood that the term depreciation, as used by an accountant, is an approximate method of gauging the loss in value since the articles were purchased : it is not intended that the allowance should be absolutely accurate, but that it should, apart from the expense of having a special valuation, reptesent the best, practical method of arriving at true, current value. The common method is to consider that each article has a certain number of years of useful life, and to take off the value of one year of that life at each annual audit. Thus. assuming that the accountant is dealing with niotar omnibuses, and that the engineer is of opinion that the motor omnibus will have five years of useful life, the accountants will, each year, deduct 20 per cent. of the cost price from the value of the omnibus, and, at the end of five years, it will have been written off entirely.

I have encountered many cases in which small proprietors have absolutely neglected the important factor of depreciation. I have known hard-working, industrious men who have been employed in connection with steam rollers, threshing engines, and steam wagons who have invested their savings in one of these machmes. The owners' experience has taught them, exactly, how much these implements can earn per day, and they have jumped to the conclusion that they were making an exceedingly good profit by letting them out on hire. Let us take cases in which steam wagons have been let out on hire at the average rate of £3 per day. The driver has said, to himself, that the only cost of the wagon was 6s. per day for his wages, 45. per day for his mate, and 55. per day for his coal, or, a total of r5s. per day. He may have recognised that there are, sometimes, expensive repairs, and he will, perhaps, have put that at 5s. per day. Ile, therefore, has thought, that the owner was makinga profit of £2 per day, and he has concluded, somewhat rashly and most wrongly, that a very good profit was being made out of it. Depreciation is, to such a man, an unknown factor, and he, therefore, interviews a maker, to know whether he can purchase a vehicle on easy terms, paying down £2oo, which be has saved, as deposit, and completing the purchase, at so much per month, which balance, he knows, he will be able to make out of the hiring. At this rate, it takes him four years to purchase the steam wagon, and, during that time, he has a fearful struggle. His repairs cost him more than, originally, he estimated, because he has to get work done where and how he can, and, not infrequently, he has to borrow some of the money to make up the amount due on each instalment. I.et us assume, however, that he is able, at the end of the four years, to complete the purchase without any outside assistance. His telea is, that he has worked very hard for those four years, and that, during that time, he has purchased a vehicle worth -Lobo, of which L200 is his original savings, and the other £400 is the profit, from the wagon's earnings. He thinks, accordingly, that he has done a very good stroke of business, inasmuch as he has a ;£600 steam wagon to show for his work. True, he has had a f..,*600 steam wagon; but it is, now, of a pattern that is out of date. It has been worked very hard, during four years, and though essential repairs will, of necessity, have been carried out, yet nothing will have been done that could be put off. to a later date ! If, at this juncture, he had to dispose of tile steam wagon, he would find that he could get, only, from £8o to £120 for it. What has, become of his original 1-;2oo of savings, and of all the profits of his four years' work? They have gone, really, in depreciation—an insidious loss, which he had not taken into his reckoning, and which he did not understand at the outset. He concludes, generally, that someone has "

done" him, and he does not know how, when, or where. I have come across several such cases, in connection with steam rollers, and one or two in connection with steam wagons. It is different with threshing tackle, as the unexpected expenses are, very frequently, much greater, and, as a nde, the purchaser makes default in his payments long before the purchase is completed, and the maker comes down and claims the tackle.

Before leaving these examples of the ignorance of depreciation, it is interesting to recount a case, in which it was reckoned twice. I was, once, asked to go through a claim for losses incurred owing to a haulier's having to go back to horse haulage instead of his continuing with mechanical transport. He bought horses and carts, especially for the work, and sold them at the conclusion. He claimed for the difference between the price he paid for the horses and carts, nnd that at which he sold them, and, in addition, he claimed for depreciation, quite ignoring the fact that the recorded clifferete:e was the real and accurate depreciation.

The accountant would have no occasion to calculate depreciation, if he could, always, get definite information, but, in the absence of it, he must adopt some simple rule that will give a good idea of the loss of value from year to year. It is, however, very necessary that the accountant should know the state of repair, or disrepair, when he is calculating the depreciation on machinery. Many machines will run for years, with only slight repairs; but, all the time, they are wearing, and, at last, all the principal parts may reach such a state of wear that the machine is fit for the scrap heap only. Such remarks apply to a lathe, in which the small traversing nuts and screws may be renewed from time to time: but the head-stock and back centre are, gradually, wearing ; the bed is getting scratched, chipped, and less capable of accurate work ; the change wheels, and even back-gear wheels, are losing teeth; and, ultimately, the lathe descends in the scale of usefulness, until it is no longer worth shop room, and is condemned for removal. A lathe has, however, a very long, life, and, if the accountant has written off a proper percentage each year, the tool will have been shown in the books, from account to account, at sonicthing near its real value. This case is typical of those where the majority of the parts of the machine wear out together, the only parts renewed from time to time being the nuts used for the tool feed, and, perhaps, the screws for them. Other machines require to have many parts renewed from tin-le to time, and, therefore, the accountant should pay regard to the amount spent on the renewals in assessing the value each year. The fairest way, in such cases, is to take a high percentage for annual depreciation, and, after deducting that from the previous plant valuation, to add the amount spent on replacements. It is quite possible that enough parts may have been renewed to leave the machine in better condition at the end of the 'financial year than at the begin-. ning, and, if the amount spent on replacements exceeds the

amount reckoned for depreciation, this result will, automatically, show itself. I can recall cases in which steam engines have been practically rebuilt, and a proper system of engineering costing and accountancy has, automatically, shown this improvement in the booked value of the engine.

The exact antithesis of the typical lathe, is the typical motor omnibus in the Metropolitan area. The vehicle has to come up, annually, for relicensing, and has to be presented, practically, in a perfect condition. The wear and tear is so great, that many parts require to be replaced several times in the course of the year, and most parts once in that time. The machinery has, so consistently, to be kept up to concert pitch, that no great difference in its value should appear from year to year. New engines are, occasionally, fitted ; new gear boxes and gears complete, new differentials, new axles, new steering gears, and, even, new frames are, similarly, substituted for the original parts, whilst wheels are changed so often that they are, generally, costed separately. The lathe depreciation represented wear and tear, but motor-omnibus wear and tear truoit all come into the maintenance account, and the chassis, from the wear-and-tear point of view, will, always, be equally good. Operating engineers can point to many vehicles which have been improved in detail, and which are, now, very much better tools than when they were first put into service, and, certainly, the 2oh.p. Milnes-Daimler omnibuses are earning as good dividends, to-day, as any of the more powerful vehicles of later date. Is there then any occasion to reckon depreciation on these chassis? Undoubtedly there is, but it represents something other than wear and tear, viz., the degree to which the chassis has become out of date, or out of fashion. Engineering science advances at such a rapid rate, that the time is sure to come when greatly improved motoromnibuses will displace, completely, the present vehicles. It is impossible to say whether petrol, steam, or electric motor omnibuses will, ultimately, oust the others, or whether petrol-electric, petrol-hydraulic, or other combination may, in the end, prove its fitness by survival, but it is sound finance to write down the value of the present chassis to provide against that day. It must never be forgotten, that the motor omnibus is a compound vehicle, consisting of a chassis. which is a machine and an engineer's job, and a body, which is a coachbuilder's job. The two are, always, repaired separately, and, in most companies, the bodies are made interchangeable for the different chassis. It follows, therefore, that separate depreciations ought to be reckoned upon for the bodies and chassis ; it may happen that sonic companies stock more chassis than bodies, because the chassis takes longer to repair, and the bodies can go to work on other chassis in the meantime. The body, in reality, comes under the same classification as the lathe, and has to be depreciated to represent wear and tear. It is true, that it is painted and varnished, each year, to look as good as new ; but, none the less, the woodwork is deteriorating, the mortice and tenon joints are loosening with the vibration to which the vehicle is subjected, and the time will come when the whole body has become so " dicky " that it must be broken up for fire-wood. It is, probably, fairest, to take the depreciation of the chassis, from the point of view of its getting out of date, at 2o per cent., and the depreciation of the body at 3 5 per cent. This second depreciation rate will be much too low for the earlier bodies, which were not made either strong or stiff enough, and some of which have, already, had to be replaced, but the bodies that are being turned out at the present day, in the light of the experience that has been accumulated during the last two years, are fully equal to a seven years' life, and, therefore, the depreciation named would be very fair.

I come, now, to quite a different point, and, having set forth a reminder that depreciation is a necessary detail of engineering accountancy, am prepared to criticise the actual method adopted for calculation of this depreciation. The usual system, the definite percentage each year, and the decrease of the booked value of the machine in an arith metical progression, does not represent the actual state of affairs, because all machinery loses a great deal of its value, in the first year, in the process of becoming secondhand. It is only in very rare instances, that any piece of machinery, such as, say, a motorcar, delivery van, or an omnibus will fetch four-fifths of its value when it is a year old. If the owner tries to sell it at that time, he will find that it has become a secondhand vehicle, and he will be lucky to get two-thirds of its cost price. It appears, therefore, that oee fifth is too little to deduct in the first year. Again, it is inaccurate to estimate that, at the end of five years, the vehicle will be worth nothing. Even as scrap metal, it will fetch a five-pound note, and, therefore, it has some real value, even. if very little.

It would be fairer to adopt a system, for the calculating of depreciation, by which the value decreased in a geometrical. progression, and this is what I have advocated, strongly, amongst all classes of engineers, for the last seven or eight. years. The method for the attainment of this correct scale of depreciation would be, the adoption of a higher percentage, and the charging of that percentage on thedepreciated book value at the last audit, instead of on the original cost price. To illustrate this, take a vehicle worth ,t,000, and. fix the rate at 25 per cent. At the end of the first year, it will be worth .4;75o ; 25 per cent, of this would be',187— deduct 4:187 from the ;6750, and the value, at the end of the second year, would be £563; 25 per cent. of this would be 4:141, bringing the value down to ..,,122; and, in succes sive years, the value will fall to .4:316, .2370 £178, -134 and i;mo. At the end of the eighth year, the vehicle will,. still, show on the books a value of .7.6too, and, provided we have used the right figure in taking 25 per cent, for this particular class of machinery, the curve of depreciation wilf represent, within small limits of error, the real value of the machinery from year to year. It will be noted, that the machine is never, actually, written off, but is, gradually, re.. duced to the scrap value. In the case taken, the vehicle is worth one-tenth of its original cost price at the end of eight years, and this, probably, states the proportion for motor lorries and delivery vans. If, therefore, the owners of these vehicles would have the courage to write off 25 per cent. the first year, and 25 per cent, of the depreciated value in each successive year, they would have, from time to time, an accurate valuation of their machinery.

The new regulations of the War Department, for the registration of motor vehicles for war purposes, does not make the system of depreciation perfectly clear, but my impression of their intention is, that the vehicles shall be depreciated in geometrical progression, rather than in arithmetical. The wording of the clause is : "The actual purchase price of the vehicle shall be ascertained and depreciated at the undermentioned rates per annum, the depreciation being deducted from the depreciated price from year to year." It is not stated, whether the annual depreciation is to be worked out on the original cost price, or on the then value. If the latter case, the Department is adopting extremely sound finance, but it is not adopting a sufficiently high rate of depreciation for the purpose. Colour is given to the suggestion, that it intends to use the geometrical progression, in as much as it adds a proviso" that the value thus calculated shall never be less than 30 per cent. of the original cost." Mr. Dugald Clerk, speaking at the Institution of Civil Engineers on the 12th instant, advanced the theory that it was possible, by altering the allowance for depreciation, to make working costs come to any figure that might be desired. He went on to say that he was driving a fourcylinder car, but might decide to sell it this spring, and to purchase a six-cylinder car. He argued that it would not be fair to consider that his present car had depreciated to the figure he would have to accept if he sold it now, as, by proper attention to its maintenance, he could keep it in equally good condition, in fact as good as new, for another ten years. In the actual words used by Mr. Dttgald Clerk, he was losing sight of the real signification of depreciation ; depreciation by wear and tear, or by loss of condition, is one thing, but depreciation by change of fashion, or by the advance of design is, none the less, very real depreciation, and is quite as important to the pockets of the owners. It is inaccurate to state, that it would be unfair to consider the difference between the present selling price, and that at which the car was bought, as depredation. This is very real depreciation, and the only accurate method of assessing it. Mr. Dugalsi Clerk probably meant that it was not correct to include this depreciation in the working costs, for comparison between those of two different cars, as the depreciation was an extra factor, depending on fashion and the popular whim, correctly chargeable in the total, but not in the working, costs.

It is not sufficient to know that depreciation has been shown in the books of any concern ; the money figured there must be earmarked and available. If the plant of a manufacturing concern has depreciated from Zio,000 to Zi,000„ the .4.9,uoo has gone somewhere, in wear and tear or other depreciation, and must be placed to reserve, or otherwise invested. In the case of a company with a public subscription, the amount of the depreciation should be put into a reserve fund, and invested in good securities, so that it can either be returned to the shareholders, or spent on fresh plant, or, in a going concern, it may well be spent, at once,. on additional plant, so as to keep the working plant up to itsoriginal value. in conclusion, it is hoped that all users of commercial motors will see that depreciation is reckoned, properly, in all their calculations as to the cot of motor transport, and, also, of horse haulage, when they wish to compare the two systems. If they have a due respect for sound and accurate accountancy, they will adopt a high percentage, and work it out on the depreciated value each year, thus adopting the geometrical, instead of the arithmetical, progression of decreasing values. Sound accountancy is as essential to successful business, as is sound management, and, in fact, is part of it, and every sum deducted for depreciation should, until required for further and more up-todate plant, be placed in a reserve fund, and that fund should be in first-class securities.


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