Depreciation Reserves as Affected by Property Growth

L. R. Nash
1916 The American Economic Review  
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more » ... out Early Journal Content at http://about.jstor.org/participate--jstor/individuals/early-journal--content. JSTOR is a digital library of academic journals, books, and primary source objects. JSTOR helps people discover, use, and build upon a wide range of content through a powerful research and teaching platform, and preserves this content for future generations. JSTOR is part of ITHAKA, a not--for--profit organization that also includes Ithaka S+R and Portico. For more information about JSTOR, please contact support@jstor.org. DEPRECIATION RESERVES AS AFFECTEI) BY PROPERTY GROWTH It is now almost universally recognized among producing industries that some regular provision should be made for replacement of equipment worn out in operation or superseded by more efficient or suitable types in the course of industrial and social development. In spite of this general recognition of depreciation the methods of providing for it are widely dissimilar. While in some cases renewals are not provided for until made, the prudent manager of a prosperous enterprise systematically builds up reserves far in advance of actual replacement requirements. It is the purpose of this paper to show that certain methods of accumulating such reserves in common use, while economically 'sound under some conditions, fail to recognize a factor of varying but sometimes very great importance. The result of neglect of this factor may be that conscientious executives will accumulate excessive reserves, thereby depriving stockholders of the full returns to which they are entitled. While errors, if any, may have been more common in the opposite direction, giving larger returns to stockholders than really belonged to them, such errors have usually resulted from failure to analyze carefully the depreciation problem rather than from oversight of any of the important factors which properly enter into such analyses. In this discussion of the subject application will be limited largely to public utilities because their consistent and rapid growth makes them particularly good illustrations. The same reasoning is equally applicable to other industries which have similar characteristics. Because of the comparatively short life and rapid development of the utility industry much of the equipment employed therein up to this time has had very limited usefulness. It is probable, however, that in the future there will be a clo;ser agreement between natural life, determined by ordinary wear and decay, and useful life, which is fixed by all elements contributing toward ultimate replacement. It should therefore be possible in the future to make more definite provision for replacements from income with tates that are at the same time reasonable and sufficiently high to take care of this feature sometimes neglected in the past. This past neglect has not all been ignorance or carelessness of operating officials or undue greed of investors. There were visions, now partiallv realized, of a vast development of business which 70 L. R. Na sh [AMarch would permiit liberal future provisions for depreciation with rates for service which were not exorbitant. If full provision had been required in the early years of the business when actual replacement expenditures required by ordinary wear and decay were small, rates for service would have been so high as to retard seriously or even prohibit the development of much needed public service. The earliest definite step taken by the utilities in providing for depreciation, as in many other fields of activity, was the reservation of a portion of the annual net profit before dividends were declared. Such reservations were not definitely fixed but were increased or diminished with good or bad business conditions. If in a term of years the total reservation was sufficient, there remained the definite advantage of a comparatively stable return on the investment. As time went on, some utilities transferred their depreciation allowances from surplus to a distinct depreciation reserve definitely held for replacement requirements. The procedure above described is open to the objection that it is indefinite and may not in the long run be adequate. There is always a temptation to distribute too liberal dividends, hoping for better business conditions in the future to build up the depreciation reserve. This objection may be met by maintaining a definite average during a term of years sufficiently long to include the usual cycle of good and bad business. This involves the necessity of determining what constitutes a suitable average annual depreciation reserve. Some utilities which have carefully studied the subject have adopted a production basis as a standard, setting aside each year a certain amount per kilowatt hour, per car mile, per thousand feet of gas, etc. Other utilities have attempted to estimate the useful life of their property and have set aside each year a corresponding percentage of its value. Still others, not having had. perhaps, suitable inventories of their properties but recognizing a fairly definite relation between propert.y value and gross earnings, have set aside each year a percentage of their gross for depreciation. This last method has the advantage of partial adjustment of the depreciation reserve to the prosperity of the business. With the advent of regulation there has developed a demand on the part of the commissions for more definite and scientific bases for insuring adequate provisions for depreciation. This movement has culminated in a requirement of the Interstate Commerce Commission that all carriers under its jurisdiction shall set aside 1916] Depreciation Reserves 71
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