Depreciation and wasting assets and their treatment in computing annual profit and loss

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DEPRECIATION
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DEPRECIATION
AND
WASTING ASSETS
AND
THEIR TREATMENT IN COMPUTING
ANNUAL PROFIT AND LOSS
BY
P. D. LEAKE
FELLOW OF THE INSTITUTE OF CHARTERED ACCOUNTANTS
IN ENGLAND AND WALES
FELLOW OF THE INSTITUTE OF DIRECTORS
FELLOW OF THE ROYAL STATISTICAL SOCIETY
AUTHOR OF
'The Question of Depreciation, and the Measurement of Expired Outlay on Productive
Plant: a Plea /or the Study and Use of Better Methods " ;
" Leake's Register of Industrial Plant for the Measurement of Depreciation, ^s\\
with Introductory Notes " ; - ; •
" The Meed of Present Accounting for Past Unexpired Capital Outlay " ;
" Can the Annual Assessment of Industrial Profit and Loss be Raised to an
Exact Science f "; " The Use and Misuse of the Sinking Fund" ; >
" Goodwill: Its Ifature and Hon) to Value It" ; etc., etc.
iOOO r-
' ^
LONDON
SIR ISAAC PITMAN & SONS, LTD., 1 AMEN CORNER, E.C.
AND AT BATH, NEW YORK, AND MELBOURNE
1917
PREFACE TO SECOND
EDITION
THIS work has been carefully revised, and three
chapters have been added dealing with the following
subjects—
The " then value " of plant as discussed in the
case of The National Telephone Company v. The
Postmaster-General.
Memorandum and criticism on the financial
proposals of the London County Council report
on London electricity supply.
Depreciation and controlled establishments.,under -;•;->, ''H'^
the Munitions of War Act, 1915. x^ \ -.'év/,^ '*<,••',\
The economic and social importance of the propelr'\^^"'\j,---^ .:^
treatment in financial accounts of depreciation and
wasting assets is becoming plain to those who are
seeking answers to the questions: " What is the fair
share of capital and what is the fair share of labour
in the annual profits of industry ? " It is obvious
that before such questions can be satisfactorily
answered, it must be possible to ascertain the annual
profits of industry with scientific accuracy which shall
exclude the irregular methods and wholesale guess­work
at present prevailing. It is only by means of
the study and use of better methods of dealing with
depreciation and wasting assets that the annual
vi PREFACE
computation of industrial profit and loss can attain
this necessary standard and become by comparison
an exact science.
The subject is well worthy of the special attention of
Scientific Institutions, Technical Colleges, and Univer­sities.
It is closely allied with other important
economic questions, one of which was recently referied
to by the President of the Engineering Section of the
British Association, when discussing the question:
" What is the workman's share under the present
state of things ? " The President pointed out that
investigation shows the average capital expended in
engineering works per individual employed is about
£200, and the dividends paid thereon average 4 per
cent, per annum ; while in normal times the average
wages for men and boys, skilled and unskilled, is about
£70 per annum. These figures disclose the interesting
fact that, according to the available statistical material,
the annual earnings of a workman are equal to the
annual earnings of £1,750 of capital; but do the
dividends paid reflect the true annual profits of
industry ?
An investment of capital in an annuity is sometimes
likened to an investment of capital in industrial plant,
because the value of each is gradually wasted and
comes to an end in the process of giving, during a
strictly limited life-period, an annual yield consisting
in each case of a mixture of capital and income. The
life-period and annual yield of any class of annuity
can be judged by a single forecast made at the time
of purchase, and its unexpired value can be after­wards
calculated ; and so the life-period and annual
yield of any class of industrial plant can be judged,
PREFACE vii
and its unexpired value calculated not, perhaps, by
a single forecast, but by forecasts based on the regular
observation of its behaviour and of the changing
conditions affecting it during its life-period.
What would be thought of a profit-seeking under­taking
with a capital invested in thousands of termin­able
annuities of different classes, if its efforts at
accounting for its capital outlay as it expired went
no further than entering the cost of all these annuities
in one summary ledger account representing capital
outlay on annuities, without any key to the whole
contents, and at the end of each year either writing
off a percentage from the balance of the ledger account
and charging the amount against the annuity revenue,
or charging the cost of fresh annuities purchased during
the year against the revenue, in the hope that the
charge against revenue would be sufficient to answer
the depreciation or expired capital outlay during the
year on the old annuities ? It is clear that such
neglect would immediately produce confusion and
chaos, which would become appalling as year followed
year, quite irrespective of whether the sums so
charged against revenue were sufficient or not.
What, then, is the difference from the accounting
point of view between such an undertaking and an
undertaking with a capital invested in industrial
plant ? The difference is only that one requires more
accounting attention than the other. Each has the
common duty to use accurate methods of accounting,
and it is no exaggeration to say that, owing to want of
systematic attention, the present state of confusion
and chaos in the records of capital outlay on industrial
plant is appalling. It is undoubtedly a common
viü PREFACE
financial practice to enter the cost of thousands of
units of perishable industrial plant, which cannot be
debited to the revenue account of the year in which
the payments are made, to some account represent­ing
capital outlay on plant, and there to leave it,
unobserved and with details lost to mind, subject
only to reduction by irregular allocations of sums out
of revenue, to answer depreciation of quite unknown
extent. The result is that the accounting records
relating to capital outlay speedily become a confused
mass of meaningless figures. No attempt is made to
keep track of the cost of each class of plant and see
that this cost, which was incurred solely on revenue
account, is duly charged to revenue over the period
which receives the benefit of the service, or useful­ness,
of each particular class of plant during its
efficient life.
If this state of affairs is admitted, the urgent need
of a remedy will also be admitted, and as a first step
towards a remedy it is suggested that every joint
stock and municipal profit-seeking undertaking using
industrial plant, should be required by statute to keep
a register of wasting assets. This register might
perhaps in the first instance apply compulsorily
only to industrial plant or other wasting assets
acquired after a certain date, and would contain
records of the unexpired cost and year of purchase,
and estimates of length of efficient life and remainder
value relating to each class. All estimates would be in
the absolute discretion of those in charge of the plant,
but it would be necessary to keep the records of un­expired
cost in agreement with the book values of the
registered plant shown on the annual Balance Sheet.
• ""W
PREFACE ix
The obligation to keep such a register of new capital
outlay on plant would direct general attention to the
subject ; and as the advantages of such records
became apparent, the pr?ctice would gradually be
voluntarily extended to include also the unexpired
capital outlay on the other plant, which would thus
soon begin to receive continuous and systematic
attention, and provision would be made for—
(1) The regular observation and record of the
behaviour of, and the changing conditions affecting,
each class of industrial plant representing capital
outlay ;
(2) The use of suitable accounting equipment in
the form of a register of plant, capable of enabling
the results of such observation and record to be
currently reflected in the annual accounts ;
(3) The adoption of a settled and continuous
financial poHcy, under which each year's revenue
account would be charged with a regularly measured
sum, based on such observation and record, to
answer capital outlay expired during the year.
And the annual computation of industrial profit and
loss would, by comparison with the present irregular
methods and wholesale guesswork, become an exact
science. The problem is doubtless a difiicult one,
but its solution is of great economic and social import­ance,
and it needs the co-operation of engineers and
accountants, and a regular system of observing,
recording, and averaging.
A grave question is raised on page 113 as to the
present financial position of large undertakings, such
as Railways, which have for many years been ac­cumulating
capital outlay on plant. How much of
X PREFACE
this capital outlay, after deducting therefrom any
available reserves, is represented by unexpired capital
outlay on existing plant ?
Attention is called on page 130 to the advantages
of issuing capital required for the purchase of wasting
assets either not needing to be renewed, or not
needing to be renewed for many years, in a form
capable of being easily paid off by annual drawings to
effect the gradual waste of the assets. In the present
state of the law, this form of capital is practically
restricted to debenture securities, but these may be
issued at rates of interest appropriate to the risks
involved, and when desirable may be issued linked
together with any issue of share securities.
The dangers of the practice of accumulating sinking
funds in outside investments, so commonly adopted
by public authorities, for ultimate repayment of
loans, are referred to in detail on page 178 and on­wards
in the course of a criticism on the London
County Council report on London Electricity Supply ;
and on pages 132 and 181 a sound alternative method
of finance is suggested, which is equally applicable to
profit-seeking undertakings having capital sunk in
such wasting assets as collieries, mines, goodwill,
patent rights, terminable concessions and the like, pro­viding
for the gradual repayment of such capital under
what is called the " distributed " sinking fund method.
It will be observed on reference to page 202 that
the views of the Ministry of Munitions as to the
proper treatment of depreciation of plant coincide
with the views advocated in this work.
P. D. LEAKE.
LONDON,
1st December, }916.
CONTENTS
PAGE
PREFACE TO SECOND EDITION . . . . . . v-x
INTRODUCTION . . . . . . . . xix-xxiv
CHAPTER I
DEPRECIATION
Definition of depreciation . . . . . . . 1
Causes of fall in exchangeable value . . . . . 1
The term " Profits, increase of value, or other advantage " . 1
Depreciation is unaffected by market fluctuations in value . 2
Market fluctuations must be entirely disregarded . . . 2
Illustration of this . . . . . . . . 2
Stock Exchange securities and the like are not wasting assets 3
The word " depreciation " has too wide a meaning . . 5
The term " Expired capital outlay " is an exact definition of
" depreciation " in its commercial sense . . . 5
Capital profits and losses which are non-inherent to profit-seeking
. . . . . . . . . 5
CHAPTER II
WASTING ASSETS
Nature of capital outlay on wasting assets . . . . 8
Definition of wasting assets . . . . . . 9
Materials held for manufacture and sale are not wasting assets,
neither are Stock Exchange securities or land . . 10
Inherently wasting assets . . . . . . . 10
Wasting assets always waste while applied to the purpose of
seeking profits . . . . . . . . 11
CHAPTER III
FIXED AND FLOATING CAPITAL
Distinction between amount of capital embarked and state of
capital investment . . . . . . . 12
Capital can exist only in exchangeable value . . 12
Capital outlay is only long-period revenue outlay . . 13
Constant interchange between fixed and floating capital . 13
Capital released from wasting assets may be otherwise laid out 14
Reduction of wasting assets is not reduction of capital . . 14
Illustration of interchange between fixed and floating capital 15
Present neglect to account for capital invested in wasting assets 20
And consequent impossibility of reasoned judgment on financial
position of an undertaking . . . . . . 21
Co-operation needed between Engineers and Accountants . 21
Present haphazard methods should be superseded , , 1%
si
xu CONTENTS
CHAPTER IV
ECONOMIC COST
Definition of economic cost . . . . . .
Factors of economic cost . . . . . . .
Economic cost is value consumed in producing value
Neglect of present accounting for past capital outlay unexpired
Depreciation is as much part of economic cost as are wages paid
Views of Economists . . . . .
Illustration of economic cost . . . .
Difficulty in computing yearly economic cost
Neglect to refund expired capital outlay out of annual revenue
receipts . . . . . . .
Overstatement of annual profits . . . .
Consequent shortage of actual capital .
And inflation of share capital . . . .
Obscurity of financial position . . . .
Need of regular accounting for capital outlay
The advantage of this compared with its cost
Payment of company dividends is not always limited by law
to amount of profits . . . . .
Legal decision, Lee v. Neuchatel . . . .
Legal decision, Lambert v. Neuchatel Asphalte Co.
Legal dicta . . . . . . .
Legal doctrine protects commercial practice
Directors are bound to make proper investigation
CHAPTER V
THE INTEREST QUESTION
Interest question deserves careful attention
Nature of interest . . . . . .
Importance of interest periods or rests
Definition of interest. Commercial compound interest
Proper use of interest . . . . .
Annuity method of computing depreciation
Illustration of annuity method . . . .
Sinking fund method of computing depreciation .
Illustration of sinking fund method
Comparison between annuity and sinking fund methods
Efifect of charging unexpired capital outlay with interest
Illustration of this effect . . . . . .
In commercial accounting interest should not be charged on
capital locked up in wasting assets
But interest is an important factor in computing cost of
production . . . . . . . .
Diminution in capital locked up in industrial plant does not
diminish the extent or efficiency of the plant
Use of annuity and sinking fund methods by municipalities
Computation of annual cost in a terminating undertaking
Interest should, in such cases, be charged on average capital
Illustration of method of arriving at average capital
Short method of arriving at average capital ,
CONTENTS xiii
PAGE
Use of interest in dealing with cost of leasehold premises . 49
Summary of conclusions . . . . . . . 50
Further arguments against the use of interest or discount in
commercial accounting, unless actually payable, or
actually receivable . . . . . . . 50
CHAPTER VI
INDUSTRIAL PLANT MEASUREMENT OF DEPRECIATION
Industrial plant the largest division of wasting assets . . 53
Extent of capital outlay on industrial plant . . . 53
Investment therein is nothing more than payments in advance
on revenue account . . . . . . . 54
Outlay on industrial plant compared with other advance
payments . . . . . . . . . 54
Agreement between capital outlay account in financial books
and register of industrial plant . . . . . 55
Expiration of time is the proper basis for measuring depreciation 56
Cost, less scrap value, should be distributed to revenue equally
over each year of the whole-life period . . . . 57
This secures a regular annual charge coinciding, roughly, with
value consumed each year . . . . . . 57
Employment of money set aside . . . . . 58
Increase in cost of repairs in later years . . . . 58
The use of existing industrial plant cannot be deferred with
impunity . . . . . . . . . 59
Treatment should be similar whether life be one or more years 60
Depreciation provision is not for future renewals, but for past
capital outlay expired . . . . . . 60
Depreciation is fall in exchangeable value over whole period of
use, and is unaffected by fluctuations in market prices . 61
Principal difficulty arises from need of making provision year
by year during period of use . . . . . 61
And suitable accounting equipment is required for this . 61
Annuity and sinking fund methods are unsuitable . . 62
Original cost basis is most suitable . . . . . 62
Industrial plant must be capable of efficient work during
efficient life . . . . . . . . 63
Proportion in which whole output is receivable period by period 64
Reducing balance of cost basis is unsuitable and misleading . 64
Reducing balance of cost basis takes excessive time at ordinary
rates . . . . . . . . . 65
Rates needed to operate within the limits of ordinary life periods 65
Effect of employing reducing balance of cost basis at ordinary
rates . . . . . . . . . 66
Illustration of reducing balance of cost basis . . . 67
Disadvantages of reducing balance of cost basis . . . 68
Simple versus complicated methods of measuring depreciation 69
Financial evils encouraged by present neglect of the subject . 70
Suggested statutory register of plant for the measurement of
depreciation . . . . . . . . 71
Check upon doubtful methods . . . . . . 72
ResponsibiUty for declaration of economic life period . . 72
XIV CONTENTS
PAGE
Register does not involve liability upon Directors . . 72
Register might be compulsory on new undertakings only . 73
Present methods may be improved . . . . . 74
French company law makes compulsory some annual provision 74
Proposed statutory register is a great advance on present
methods . . . . . . . . . 75
CHAPTER VII
INDUSTRIAL PLANT-—RECORD OF DEPRECIATION
Annual revenue account should not be charged with cost of
new plant or renewals, but should be charged with
measured depreciation . . . . . . 76
Difficulty of distinguishing between additions and renewals . 77
Proposed register of plant obviates this difficulty . . . 77
Use of official schedule of capital outlay to avoid danger of
charging cost of small renewals and repairs to capital
outlay 78
Treatment of scrapped or abandoned industrial plant . . 79
Loose tools and utensils . . . . . . . 79
Convenient form of register of plant . . . . . 79
Register will show many years' history of scores of classes
of industrial plant . . . . . . . 82
Measurement of depreciation each month if desired . . 83
Division of industrial plant into classes . . . . 83
Identification of plant by distinctive numbers . . . 84
Working illustration of register of industrial plant . . 84
Electric tramway undertaking . . . . . . 84
Annual outlay compared with annual depreciation . . 84
Reason for diiïerence in annual depreciation in illustration . 86
Class record in register of industrial plant . . . . 88
Class summary in register of industrial plant . . . 88
Annual general summary in register of industrial plant . 89
Further illustration of register of industrial plant . . 93
Particulars of illustration . . . . . . . 93
Class record . . . . . . . . . 95
Class summary and annual general summary . . . 97
In the case of an established undertaking . . . . 97
Method of registering outlay and measuring depreciation . 98
Initial difficulty in the case of an established undertaking . 99
Class record for meters of a gas company . . . . 100
Need of back years' records . . . . . . 1 00
Apparent difficulty in the case of some established undertakings 103
Method of revising estimates of life periods and scrap values . 104
Illustration of this method . . . . . . 104
Simplicity of method . . . . . . . 1 06
Use of remainders in building new plant . . . . 108
Accidental destruction of plant . . . . . . 1 08
Outlay on plant at intervals during life period . . . 1 08
Treatment of proceeds of sales of scrap . . . . 1 09
Adaptable nature of register . . . . . ,109
Sectional registers of plant for large undertakings . . Ill
Schedules of expenditures to be charged as capital outlay . Ill
CONTENTS XV
* PAGE
Gigantic capital outlay on plant . . . . . 1 11
Gradual development of registers of plant . . . . 1 13
Explanations and illustrations are incomplete . . .114
CHAPTER VIII
NATURAL RAW MATERIAL AND RECURRING CROPS
t)escription of wasting assets under this head . . .116
Extent of capital outlay on natural raw material and recurring
crops . . . . . . . . . 1 16
All are payments made in advance on revenue account . . 117
Depreciation and natural raw material . . . . 1 17
Depreciation and recurring crops . . . . . 1 18
Depreciation factors to be considered . . . . 1 18
Depreciation and collieries, mines, etc. . . . . 1 19
Wasting assets dealt with in this chapter all come to an end in
yielding their product. . . . . . . 1 20
Inconvenience of repaying capital in the form of ordinary
dividends . . . . . . . . . 120
A remedy for concealed reduction of capital, and an example 121
Illustration of proposed remedy . . . . . .122
Present " case " law allows concealed reduction of capital . 122
Depreciation and mine development . . . . .122
Accounting equipment for recording depreciation . . 1 23
CHAPTER IX
PURCHASED TERMINABLE ANNUITIES
Nature of purchased terminable annuities . . . . 1 24
Loans repayable with interest in equal annual payments . 124
Illustration of meaning of present value of an annuity . .124
Illustration of annuity certain . . . . . . 1 25
Illustration of life annuity . . . . . . 1 26
Factors in annuity can be easily separated . . . . 127
Interest factor diminishes annually . . . . .127
CHAPTER X
PURCHASED TERMINABLE CONCESSIONS LEASEHOLDS
Inherently wasting assets, and other wasting assets . . 128
Value of concessions and leaseholds consists of rights to future
pure profits
Purchased terminable concessions
Consideration is future pure profit paid in advance of its arising 129
Illustration of purchased terminable concession . . . 1 30
Annual provision for expired capital outlay . . . 1 30
Capital should be raised in suitable form . . . . 130
Debentures bearing high rate of interest . . . . 132
" Distributed " sinking fund method 133
Legal facilities needed to enable surplus share capital to be
repaid to shareholders 134
Leaseholds . . . . . . . . . 134
Repairs and maintenance at cost of lessee . . . . 1 35
Repairs and maintenance at cost of lessor . . . . 135
Importance of distinction between the two kinds of wasting
assets . . . . . . . . . 1 36
128
129
^^'
xvi CONTENTS
CHAPTER XI
COPYRIGHTS—PATENT RIGHTS—GOODWILL—TRADE-MARKS
Characteristics common to these wasting assets
Nature of their exchangeable value
Expected future super-profits
Provision for expired capital outlay
Copyrights . . . .
Patent rights . . . .
Goodwill—Trade-marks
Goodwill must be written off
Substituted exchangeable value is not a sound alternative
Increase in value of goodwill is not part of annual profit
Illustration of accounting for capital outlay on goodwill
CHAPTER XII
WASTING ASSETS AND AN INCOME TAX ON ANNUAL INCOME
Need of reasonably accurate methods of computing annual
profit and loss . . . . . . .
Danger of levying income tax on that which is not income
Opportunity to encourage proper accounting
Surplus of annual receipts versus economic profit
British income t ax . . . . .
Original difficulties and scheme of assessment
Antiquated precedents . . . .
Expired capital outlay largely ignored
Inadequate allowances and inadequate methods of accounting
Wear and tear computed on reducing balance of cost
Amount of wear and tear allowance is in absolute discretion of
Commissioners . . . . . . .
Special concession under Section 39 of Finance Act, 1916
Nature of allowances for diminished value which cannot
properly be claimed . . . . . .
Wasting assets which are not inherently wasting assets
Leasehold property . . . . . . .
Deduction allowed for repairs . . . . .
No further allowance for depreciation of leaseholds
permissible . . . . . . .
Deduction allowed for maintenance, repairs, insurance, and
management of land and farm buildings
Maintenance includes cost of replacement of farm buildings, etc
Shortcomings of present scheme of British income tax assesS'
ment as regards depreciation allowances
Memorandum on wasting assets and income tax .
Alternative definition of the two classes of wasting assets
CHAPTER XIII
THE " THEN VALUE " OF PLANT
The National Telephone Co.'s case . . . . . 1 61
Question to be determined . . . . . .161
Life of plant 162
Depreciation of plant on straight line method . . . 162
CONTENTS XVll
137
137
138
138
138
139
140
140
141
142
142
145
145
145
146
146
147
147
148
148
148
149
150
150
151
152
152
153
154
154
155
156
160
161
161
162
162
Depreciation of plant on sinking fund method . . . 163
Illustration of company's argument . . . . . 163
Sinking fund method rejected by the Court . . . 164
Absence of regular provision for depreciation, and methods
of meeting this difficulty . . . . . . 165
Obsolescence . . . . . . . . . 168
Loss by accident, etc. . . . . . . . 169
Kevision of estimates of efficient life . . . . . 169
Reply to company's sinking fund argument . . . 170
Commercial view of going-concern value of plant . . . 1 71
The " then value " of plant . . . . . . 172
Deducting a percentage from reducing balance of cost . . 1 72
Outlay on additional or on improved plant . . . . 1 72
When money is invested in plant, considerations of interest
disappear . . . . . . . . . 172
Value of goodwill distinguished from value of plant . . 173
Capital invested in plant compared with capital invested in
stock or debts . . . . . . . . 174
Effect of annuity or sinking fund method illustrated . . 1 74
CHAPTER XIV
MEMORANDUM AND CRITICISM ON THE FINANCIAL PROPOSALS
OF THE LONDON COUNTY COUNCIL REPORT ON LONDON
ELECTRICITY SUPPLY
Criticism of financial proposals of London County Council . 178
Character of proposed new undertaking . . . . 1 78
Proposed sinking fund method to maintain capital value . 179
Need of a method giving closer touch with existing conditions 180
Reasons for this 181
Possible distinction between long-life and short-life plant . 181
Illustration by an assumed case . . . . . . 182
Distributed sinking fund method applied to cost of long-life
plant 183
Special provisions needed to meet conditions inherent to short-hfe
plant 184
Financial position at end of fifty years in assumed case . . 185
Maintaining capital value in addition to repaying capital out
of revenue . . . . . . . . 186
Plan to secure close co-operation between engineers and
accountants in mantaining value . . . . 1 87
Treatment of cost of additions and extensions . . . 188
Importance of nearest possible approximation to annual profits 188
London County Council proposals for dealing with " net
revenue " 189
Uncertainty of annual " surplus profits " under the proposals 190
Haphazard nature of proposals for dealing with capital outlay 190
Further illustration of the effect of the sinking fund theory . 192
What is an annuity ? 192
Annuity scale of value unsuitable to measure value of plant 195
Surplus interest of later years, if any, is a factor of goodwill 198
E—(1345)
..i
XVIU CONTENTS
CHAPTER XV
DEPRECIATION AND CONTROLLED ESTABLISHMENTS UNDER
THE MUNITIONS OF WAR ACT, 1915
Treatment of depreciation by Ministry of Munitions
Adoption of definition of depreciation given in this work
Controlled establishments and net profits
Importance of depreciation . . . . .
Adjustments allowed in determining net profits .
Determining net profits for the final period .
Probable value of munitions plant to controlled owner at end
of the period of control . . . . .
Uncertainty of length of period of control .
Settling an amount to be written off as a final settlement
Exceptional depreciation or obsolescence of plant allowed by
Ministry of Munitions to be also allowed by Inland
Revenue in assessing profits for income tax .
202
202
203
203
204
205
205
206
207
208
INSETS.
1. Table showing the proportion of the whole-life output of
industrial plant receivable annually, in comparison with the
proportion of the cost charged annually to revenue under
various methods of distribution in common use end of book
2. Table showing amount of depreciation per cent, of original
cost, written off in each year on the reducing balance of
cost basis at various rates between 3 and 33 J per cent, end of
book
3. Table showing surviving value per cent, of original cost
remaining at the end of each year on the reducing balance
of cost basis at various rates between 3 and 33^ per cent, end
of book
INDEX 209
INTRODUCTION
BECAUSE it closely concerns Profit and Loss, the
subject of Depreciation and Wasting Assets is of
universal importance, and yet it has hitherto received
little or no systematic attention. But it is evident
that this neglect cannot continue indefinitely, in view
of the present great and growing need for the use of
reasonably accurate methods in computing annual
profit and loss, for the following amongst other reasons :
The enormous and increasing development of joint stock
and municipal trading enterprise, with the consequent passing
of capital—which half a century ago was retained and managed
by individual owners, or lent on specific mortgage—to the
care and management of others, who are expected to uphold
the value of the capital investment, and to ascertain and
distribute the annual profits with due regard to the difier-ential
rights of holders of cumulative and non-cumulative
preferred, ordinary, deferred, and other classes of shares.
The increasing adoption of schemes of profit-sharing
co-partnership between capital and labour.
The increasing burden of income taxes assessable on annual
profits arising.
The increasing burden of rates assessable on annual value.
The increasing demands of labour for higher wages and
other consideration, based on the declared annual profits
earned by capital invested in industry and commerce.
The increasing demands for reduction in charges for the
supply of municipal and other public services in the nature
of monopolies, such as railways, tramways, electricity, gas,
etc., based on the declared annual profits earned by the
operation of such services.
No equitable adjustment is possible under any of
these heads without the reasonably accurate computa­tion
of annual profit and loss, and this can never
X l ^
XX INTRODUCTION
be attained without systematic attention to the sub­ject
of Depreciation and Wasting Assets. In these
circumstances, it is startling to find the general admis­sion
that the subject is in an altogether neglected
and chaotic state, coupled with the further general
admission that, unless a near approximation to the
outlay on wasting assets which has expired within
each year (depreciation) is made and fully provided
for by being refunded out of the revenue receipts of
the year, no correct statement of annual profit or loss
can be obtained.
In the middle of the nineteenth century, when
commerce was carried on by individuals, each on his
own account, in a vast number of small undertakings,
and there was no regular income tax, it was a matter
of small moment to the individuals concerned to
enquire whether in each case the surplus of cash
receipts in or about each year, after payment of the
actual cash outgoings, and allowing for difference in
stock-in-trade, was wholly economic profit of the year,
or whether capital outlay, previously made for the
purposes of the business, had been wasted or used
up in the course of the year's operations, involving,
therefore, another kind of expense and consequent
reduction of the surplus of cash receipts by the amount
of capital outlay so used up before arriving at annual
profit. It was sufficient for their purpose that the
surplus balance of cash receipts in each case, however
large, should be available for use as and when needed.
Since that time the conditions under which com­merce
is carried on throughout the world have com­pletely
changed, and the great bulk of it is now
controlled, not in gmall units each by an individual
INTRODUCTION XXI
owner, but in the form of great enterprises, under the
guidance of a comparatively few highly-qualified
directors and managers acting as agents for a vast
number of owners who themselves know nothing about
the business. In these circumstances, directors and
managers are obviously expected to seek and use the
best available means for computing with reasonable
accuracy the profit or loss resulting from the operations
of each year. It is strange, therefore, that the subject
of Depreciation and Wasting Assets has hitherto
received so little systematic attention, for it represents
a large and regularly recurring part of economic cost,
and it is impossible to determine the profit or loss
resulting in a given period from any enterprise without
first ascertaining the economic cost incurred during
that period.
To call attention to the remarkable absence of any
attempt to deal with depreciation in a systematic and
regular manner is not to say that sufficient provision
is not made in the long run, by hook or by crook, for
this important part of economic cost by weU-managed
undertakings. But it is quite evident that, even if
approximately correct long-period results are obtained,
the present precarious and uncertain way in which
depreciation is charged to annual revenue often causes
the declared annual results to oscillate between one
year and another, although the movement of the
business during the period may have had a quite
regular tendency. The reason is that the charges
made to revenue under the head of depreciation in a
given year have often little relation to the true benefit
receivable by revenue during that year from the use of
the wasting assets. The subject is thus of public
I fi-n—
XXll INTRODUCTION
importance even as it affects enterprises administered
in an able and honest manner, but it assumes far
greater gravity in connection with that large class of
undertakings which are habitually carried on under
less sound and capable management.
It must also be noted that the regular treatment
of Depreciation and Wasting Assets is necessary to
determine with accuracy the annual cost (apart from
questions of profit or loss) of producing commodities
and of rendering public services, and it is thus of great
importance to the internal management of industrial
undertakings in all questions concerning competitive,
comparative, or recurring cost, including—
Computing cost of production, for the purpose of fixing
and grading competitive selling prices to customers.
Comparing cost of production by machine and hand
processes respectively.
Comparing cost of out-turn of machines of different age or
character.
Comparing cost of successive similar factory production
orders.
A principal object of this work is to show that the
present neglect to account systematically year by year
for expiring capital outlay made in advance on revenue
account is a matter of long-established custom rather
than of inevitable necessity. Absolute accuracy cannot,
of course, be attained, but a system giving results
nearly approaching to accuracy by comparison with the
present complete lack of method may be easily attained.
The accounting for capital outlay, dedicated as such
outlay always is to a certain purpose, constantly
expiring, and which, rightly considered, is entirely
unaffected by current market fluctuations in value,
is as important as is the accounting for current cash
::i
INTRODUCTION xxiii
expenditure, which is now always minutely recorded
and controlled in its thousandfold greater detail.
Any class of wasting assets used in profit seeking is
surely worth the making of a simple accounting record
each year during the period of service within which
the usable value must expire. All that is needed is
the use of a suitable accounting equipment, supple­mentary
to the ordinary financial ledgers, which shall
record the estimates of the engineers or other technical
advisers, and enable the accountants to give due
financial effect to such estimates. Such an accounting
equipment would form an invaluable key to the details
of the capital investment in wasting assets as shown
in total in the ordinary financial ledgers.
The vital importance of the whole subject has always
been insisted upon by professional accountants, and
its neglect continues in spite of, and not in conse­quence
of, their attitude. When public and official
opinion demands it, the present evil can be largely
remedied without encountering any insurmountable
difficulties, and at a cost infinitesimal compared to the
value of the benefits obtained ; but, until that time
arrives, professional accountants are unable to give
much effective aid.
The problem of Depreciation and Wasting Assets is
so vast and complex, that it is apt to appal and dis­courage
any sustained striving after the use of better
methods. But it is clear that a great advance in the
direction of improvement is easily attainable by taking
thought, and some attempt is here made to set out
the results of a general survey of the subject, on a
basis wide enough to include every part, in the hope
of assisting to influence opinion, and of attracting the
xxiv INTRODUCTION
attention of those best able to develop the many and
widely different branches of the problem. With this
object in view, the Author will be greatly obliged to
any interested in the subject who may be so kind as
to submit suggestions and criticisms.
P. D. LEAKE.
DEPRECIATION AND
WASTING ASSETS
CHAPTER I
DEPRECIATION
IN its true commercial sense, the word " Depreciation " Definition of
' -^ Depreciation
means fall in exchangeable value of wasting assets,
computed on the basis of cost expired during the
period of their use in seeking profits, increase of value,
or other advantage. Depreciation is a part of the
cost of seeking profits, equal in importance to other
revenue expenditure.
The fall in exchangeable value of wasting assets causes of fan
during the period of their use in seeking profits may aWe value
be due to any one or more of the following causes—
Expiration of time.
Natural decay.
Wear and tear.
Obsolescence.
Diminution of the mass or source of natural raw
material.
Diminution of the principal sum involved in
contracts such as purchased terminable annuities.
The term " profits, increase of value, or other Jhe term
'^ profits, in-advantage
" includes not only all kinds of industrial „"othe'"^'""'
and commercial profits, but it also includes the ^''^""se"
accruing interest contained in contracts such as pur­chased
terminable annuities, and aU accruing benefits
(having exchangeable value) which are received in any
1
"—(1345)
2 DEPRECIATION AND WASTING ASSETS
form other than cash, such as the annual value of a
house occupied by the owner, or of furniture, or horses
and carriages used by the owner. As, however,
private users do not generally have occasion to com­pute
with accuracy the annual cost of their own
establishments, this part of the subject is of little
interest from a practical point of view.
Depreciation is It is important to obscrvc that it is the fall in
unarfectea by ^
tiiftioL^ia' exchangeable value occurring during t h e whole period
value Qf ygg^ a,nd, further, that during that period wasting
assets are not primarily intended for sale in their
existing form. They are, in fact, out of the market,
being all the time allocated to the specific purpose
of seeking profits in the pursuit of which they will
be destroyed, except as to any scrap or remainder
value which may ultimately survive. Depreciation
of wasting assets is, therefore, unaffected by market
fluctuations in value due to the operation of the law
of supply and demand during the currency of the
period of their use.
Market flue- The failurc to recognise this fact is responsible for
tuations must ° -^
dfsregarïèd ^^^^ P^^^ ^^ *^^ difficulty surrounding the subject of
depreciation which arises out of the common belief
that regard must be had to fluctuations in value due
to the temporary state of supply and demand. All
such fluctuations must be entirely disregarded, except
always in so far as they may safely be taken as useful
indications in revising earlier estimates of the ultimate
exchangeable value (if any) likely to survive at the
end of the period.
Illustration of A profit-sceking undertaking using wasting assets
is, and for accounting purposes must always be treated
as, a going concern ; and a going concern will apply
DEPRECIATION 3
its wasting assets to the purposes for which they were
acquired, and will not act as a dealer in the purchase
and sale of such property for profit. Therefore, after
the purchase of wasting assets at a certain cost, be it
high or low, the accounting problem is confined to the
proper distribution of that cost over the years of the
efficient life of the wasting assets. Suppose a machine
costs ;^1,100, with expected life ten years and scrap
value ;£100, the proper provision for depreciation is
i^IOO a year. It makes no difference at all that in
five years the market price of such a machine may
have advanced to £1,500. It is still only necessary
within the ten years to refund the cost of the machine
which was purchased for £1,100. When it becomes
necessary to purchase another machine at the end of
ten years, it may cost £1,500, which will need a capital
outlay of £400 in excess of that needed for the pur­chase
of the first machine ; but this circumstance
does not render inadequate the charge of £100 per
annum for depreciation on the first machine, which
cost only £1,100. It cannot be too clearly stated
that depreciation extends only to the replacement
of the cost of wasting assets already acquired and
which are being wasted in the process of earning the
revenue of an undertaking. The provision is not to
cover the cost of future renewals, although it wiU be
available to be appUed to or towards that cost.
The word " depreciation " in its commercial sense stock
1 1 • 1 • '11 1 1 Exchange can apply only to wastmg assets, and it will be shown securities and
T -r , ° the like arc not
later that all wasting assets must inevitably waste and wasting assets
pass away while applied to the purpose of seeking
profits, increase of value, or other advantage. Stock
Exchange and other like securities are not wasting
DEPRECIATION AND WASTING ASSETS
assets ; they are held, as a rule, for the purpose of
obtaining the income receivable from them in the
form of annual dividends, and although such securities
may at any time either appreciate or depreciate in
market value, this change in value will not arise out
of the purpose for which they are held, and thus they
are clearly distinguishable from wasting assets. This
applies equally whether the securities are held as
investments for the purpose of receiving the annual
dividends, or bj' a dealer or speculator for the purpose
of selling at a profit ; for in neither case does any
movement up or down in their exchangeable value
arise directly out of the purpose for which they are
held. Movements up or down in value of Stock
Exchange or other securities are, of course, of every­day
occurrence and arise from various causes, but the
cost of the securities does not expire in pursuit of the
object sought to be attained, as it always does expire
in the case of wasting assets. Realised losses on the
sale of investments in Stock Exchange and other
securities may thus be clearly distinguished as
" capital" losses by the application of this test.
When such losses are incurred by a profit-seeking
enterprise having part of its funds invested in outside
securities, such realised losses should no doubt be
refunded or made good out of profits retained in hand
for that purpose, and the same applies to any fall in
the value of investments when it is considered that
the loss may be permanent, but this is quite distinct
from commercial depreciation. All such refunds of
" capital" losses are made out of true profits arising
from the undertaking, except, of course, in the case
of a financial enterprise specifically seeking profits
DEPRECIATION 5
from the purchase and sale of investments, when the
securities are, to the financial enterprise, much the
same as the stock-in-trade is to the industrial
undertaking.
The word " depreciation" is unsatisfactory as a The word
Deprecia-definition
of that which it is intended to imply, for tion"hastoo
^ -^ wide a
it means much more than is intended ; thus, a fall in meaning
the value of Stock Exchange securities held by bankers
and others is no doubt correctly described as deprecia­tion
in the sense opposite to appreciation. Besides
being commonly used to express fall in aU exchange­able
value, whether existing in the form of wasting
assets or otherwise, the word is also used in the sense
of lowering in estimation, thus—
" A method . . . which much depreciates the esteem and
value of miracles." 1646. Sir T. Browne. Pseud. Ep. IV,
X, 205.
" A great depreciation of the standard of morals among
the people." 1829. J. Taylor. Enthus. IX, 225.
" Our architectural reputation, never high, is still more
depreciated by the building at South Kensington." 1862.
Fraser's Magazine, November, 631.
The term " expired capital outlay" is an exact
definition of that which the word " depreciation " is
intended to imply when used in its commercial sense,
and the general adoption of this term would avoid the
common mistakes arising from a natural belief that
" depreciation" covers at least all that which is
opposite to appreciation.
A clear understanding of the true meaning of
' depreciation" as being expired capital outlay,
enables questions which have been raised from time
to time by legal writers to be easily answered; thus
The term
" Expired
Capital Out­lay
" is an
exact defini­tion
of
" Deprecia­tion
" in it?
commercial
sense
Capital profits
and losses
which are non-inherent
to
profit-seeking
6 DEPRECIATION AND WASTING ASSETS
Buckley, L.J., in his work on the Companies Acts,
in discussing depreciation, asks this question—
Suppose I buy £100 Consols at 80, and at the expiration
of a year they have fallen to 77J, is my income £2 10s. or
nothing ? If nothing, then if at the expiration of the year
they had risen to 82J, my income would, by comparative
reasoning, have been £5, not £2 10s. Is the result affected
by the question whether at the end of the year I am or am
not, about to sell my Consols ?
The answer to the first question is, that the fall of
£2 10s. in the value of the £100 Consols not being a
loss resulting inevitably from the holding of the
Consols for the purpose of receiving the £2 10s. divi­dend,
is a capital loss. It is not commercial deprecia­tion,
and is not a charge against the income. Capital
losses may perhaps be defined as the fall in exchange­able
value of property not applied to the purpose of
seeking profits in such a manner as to cause it inevit­ably
to diminish or expire, and the capital invested
in this £100 of Consols for the purpose of earning the
£'2 10s. dividend was not applied in such a way as to
cause it inevitably to diminish in value. By the
same process of reasoning, the answer to the second
question is, that the rise in value of the Consols to
82-| results, if the Consols are sold, in a capital profit
of £2 10s. which is of a different character to the
dividend of £2 10s., and may be treated as income or
not, at the option of the person concerned. The
answers are unaffected by the question whether or
not the Consols are about to be sold at the end of
the year.
Another question in the same work is as follows—
Suppose a tramway company lays its line when material
and labour are both dear; both subsequently fall, and the
DEPRFXIATION J
same line can be laid for half the money, and, as an asset
(independent of depreciation from wear), is worth only half
what it cost. Is the company to make this good to capital
before it pays a further dividend ? If so, then, if the cost
of material and labour had risen after the line was laid, might
not the company have divided as dividend this aggregation
to capital ? Upon such a principle, dividends would vary
enormously, and sometimes inversely to the actual profit
of the concern.
This question brings out clearly the importance of
understanding the true meaning of depreciation in its
commercial sense, which is nothing more or less than
" expired capital outlay." The tramway company no
doubt laid out its capital to the best advantage at the
time of installing the tramway, and having made the
bargain and bought the property, whether the price
was high or low, the sole question for the company in
preparing its annual revenue accounts is as to how the
cost, which is expiring over a long period of years, is
to be fairly allocated as a charge against the revenue
account of each year for expired capital outlay. The
company must, after the tramway has been laid and
equipped, disregard all subsequent fluctuations in the
value of material and labour for the reasons stated
above, except in so far as these may safely be taken
as useful indications in revising earlier estimates of
the ultimate scrap values.
CHAPTER II
Nature of
capital outlay
on Wasting
Assets
WASTING ASSETS
THE majority of profit-seeking enterprises have to
embark capital in wasting assets to enable them to
earn their revenue, whether arising from the winning
and sale of coal or minerals, as in the case of a coUiery
or mine, from traffic receipts, as in the case of ? rail­way
or tramway company, from the supply of elec­trical
energy, gas, water, or other public service, or
from the manufacture and sale of goods. It is,
unfortunately, customary to record and describe
capital laid out in wasting assets such as coal measures,
mineral deposits, buildings, plant, machinery, and the
like, as fixed or permanent, this custom having arisen
out of a misapprehension of the facts. Consideration
will show that all such outlay of capital, far from being
represented by anything fixed or permanent, consists
of nothing more enduring and substantial than expiring
value ac(]uired and paid for in advance on revenue
account for the purpose of enabling the gross revenue
to be earned, in which process the value of all these
wasting assets will inevitably be destroyed. Wasting
assets of all kinds, unlike trade stock, are not for sale
as such, but are deliberately dedicated to be destroyed
in carrying on the undertaking. All subsequent
fluctuations in the market value of similar property
are thus immaterial, and consequently should be
deliberately excluded from the accounts, the sole
question being how to apportion the cost of the wasting
assets (a known amount be it observed) fairly over
WASTING ASSETS 9
each of the Hmited number of years which will benefit
by the outlay. Undertakings using wasting assets
(which are defined below) in earning their revenue
incur each year expenditure under two distinct heads,
one being that expenditure for which cash has to be
disbursed at the time, or in or about the year the
benefit is received, as, for instance, wages, rent, and
the like; and the other being represented by that
part of the previously incurred capital outlay which
has expired within the year, and this latter head of
expenditure is at present grievously neglected in
accounting.
Wasting assets consist of all values of an exchange­able
nature which inevitably diminish while applied
to the purpose of seeking profits, or advantage other­wise
than by purchase and sale, and they include the
following—
(a) Industrial plant comprising all perishable material
property other than that primarily intended for re-sale.
Such plant includes all buildings, plant, machinery, fixtures,
and furniture of manufacturers; all buildings, plant, machinery,
fixtures, and furniture of mines; and all surface works (reser­voirs,
water service, railway sidings, roads, etc.); the way,
bridges, works, stations, rolling stock, and all equipment of
railway and tramway companies, other than site value of
land in each case. Most of the capital of electric lighting
and power companies; gas, water, and omnibus companies;
cable, telegraph, and telephone companies; shipping and dock
companies, as well as that of many other undertakings, is also
invested in perishable industrial plant. The undertakings
least affected are banking, insurance, investment, and finance
companies.
(6) The mass or source of any natural raw material,
including bodies of coal and all kinds of minerals; deposits
of slate, stone, gravel, earths, oil, and nitrate; also timber
and all kinds of growing plants yielding recurring crops.
(c) Main shafts, main adits, shafts which develop ore, and
10 DEPRECIATION AND WASTING ASSETS
other underground development undertaken to win natural
raw material.
(d) Purchased terminable annuities.
(e) Purchased terminable concessions.
(/) Leaseholds.
(g) Copyrights.
(h) Patent rights.
(/) Goodwill and trade-marks
Materials held
for manufac­ture
and sale
are not
wasting assets,
neither are
Stock
Exchange
securities nor
land
Inherently
wasting
assets
Purchased materials and stock held for the purpose
of manufacture and sale are not wasting assets, neither
are gotten minerals and the like, nor severed crops, for
they are all held for the purpose of manufacture, or
sale, and do not inevitably fall in exchangeable value
during any period of use in seeking profits. Gotten
minerals are easily distinguishable from the mass or
source of the natural raw material, for the latter,
when applied to the purpose of seeking profits, inevit­ably
falls in exchangeable value during the period of
its use in consequence of the gradual reduction of the
mass, or source, as the product is won. It has been
explained in the previous chapter that Stock Exchange
securities and the like are not wasting assets. The
site value of land is not a wasting asset; its value
does not inevitably diminish while applied to the
purpose of seeking profits otherwise than by purchase
and sale of the land.
Wasting assets falling under the four heads (a) to
(d) are inherently wasting assets, being represented
by a corpus or fund (apart from the value of mere
rights to future profits or increase) which wastes in
the process of seeking profits. Wasting assets falling
under the remaining five heads (e) to (i) are not repre­sented
by a corpus or fund apart from the value of
terminable rights to future profits, increase of value,
WASTING ASSETS 11
or advantage. This distinction is of importance,
especially when considering the assessment to income
tax of annual profits arising.
All wasting assets, whether consisting of a corpus *s^ets°fiways
or fund which inherently wastes, heads {a) to (d), or rp*pfiea'iQ''the
of terminable rights to future profits, increase of K^ktogp^fits
value, or advantage, heads (e) to (i), have the com­mon
characteristic that they inevitably fall in exchange­able
value while applied to the purpose of seeking
profits ; and unless an amount equal to this fall in
exchangeable value is retained out of the revenue
receipts of an undertaking by being charged to the
revenue account as part of the cost, the cost will be
understated to that extent and the profit overstated
by a like amount. It is easy to ascertain the fall in
exchangeable value which has taken place in a wasting
asset at the end of the period of its efficient life ; but
at any time during the currency of that period this
can only be a matter of estimate having regard to all
known existing conditions and to probable future
developments.
CHAPTER III
Distinction
between
amount of
capital
FIXED AND FLOATING CAPITAL
IT is necessary to distinguish clearly between the
definite amount of capital embarked in a profit-
™tlfSfctpifa'i seeking undertaking and the temporary states or forms
investment QJ investment in which that capital afterwards exists
from day to day, and to bear in mind that the turning
of some of these forms of investment into other forms
of investment, or into money again, is not in any
sense a reduction of the capital of the undertaking.
The capital of every profit-seeking undertaking is
required for two well-defined purposes : first, to pur­chase
the necessary wasting assets and sometimes
land (this part of the capital being often called fixed
' capital) ; and, secondly, for use in the form of other
necessary assets, such as sale stock, debts, temporary
investments, and cash at bank, this part being called
circulating or floating capital. The whole capital out­lay,
however, both fixed and floating, save that on
land, is constantly circulating and passing from one
form of investment to another, although at very
different rates of speed.
Capital can exist only in exchangeable value, and
therefore capital can only be fixed by maintaining
investments, in some form or other, at an exchange­able
value equal to the fixed capital. As wasting
assets in which capital resides become less in exchange­able
value, some other form of exchangeable value
arises which increases other assets, such as sale stock,
debts, bank balances, or temporary investments.
Capital can
exist only in
exchangeable
value
FIXED AND FLOATING CAPITAL 13
This must happen automatically when an undertaking
results in true economic profit, provided that no
greater sum than the profit is withdrawn ; but when
the undertaking results in a loss, or a sum greater
than the profit is withdrawn, the capital cannot be
maintained except by introducing fresh value.
The theory that the capital and revenue outlay f/PJJiy "^„gj'
accounts of a profit-seeking undertaking are distinct, ouuay'^"™"'^
in the sense that the accounts relating to capital out­lay
can be partitioned off and treated as the capital
account, is a fallacy. All capital outlay on wasting
assets consists merely of payments made in advance
on revenue account, all of which are constantly
expiring in the service of the revenue account, and,
therefore, the value of the capital investment cannot
be upheld except by regular and adequate contribu­tions,
which must be retained out of revenue receipts
by being charged to revenue account. These con­tributions
need not remain lodged in the bank until
the money is required to renew the wasting assets.
The swelling balance at the bank should in the mean­time
be used, as it generally is used, if required, for
the ordinary purposes of the business.
It increases for the time being the available floating constant
^ o interchange
or circulating capital, and, as the moneys representing ^afloatfng'*
the contributions are retained out of revenue receipts, "^"^'"^
the requirements of the business may simultaneously
increase to an extent demanding the permanent use
of these moneys as additional floating capital. Again,
if not used to answer a growing need for further floating
capital, the contributions may be gradually absorbed
by the purchase of additional wasting assets, such as
further plant, permanently required by the undertaking.
14 DEPRECIATION AND WASTING ASSETS
Capital
released from
wasting assets
may be other­wise
laid out
Reduction of
wasting assets
is not
reduction of
capital
In either of these cases, when it becomes necessary'
to renew the original wasting assets, and bring them
up to their value again, the money, although specifically
contributed by revenue year by year in the past, will
not be found at the bank available for use. The
reason is that it has been already invested to answer
the growing need of the business for new capital, and,
therefore, directly the money is required for its origin­ally
intended purpose, it is legitimate and necessary
to increase permanently the capital of the undertaking
by issuing new capital, and to use the money provided
by this increase of capital to renew the original wasting
assets, because the undertaking now needs a per­manently
larger capital, fixed and/or floating. In the
meantime, sums in lieu of this new capital have been
borrowed year by year, as above stated, out of the
proceeds of the gradual return of the money laid out
in the wasting assets which formed part of the original
" fixed " capital investment.
The use of the new capital for the renewal of the
original wasting assets will operate to pay back the
temporary loan which was legitimately borrowed from
the original " fixed " capital, at a time when the money
would otherwise have remained unemployed in the
business. Thus the operation of exchanging into other
forms of value, and so gradually using up and reducing,
what are called fixed assets (although really wasting
assets) in the ordinary course of carrying on the busi­ness
of a profit-seeking undertaking is not reducing the
capital of the business, for the capital (or exchangeable
value) will be found residing in some other asset
received in exchange, which may be in the form of
sale stock, debts, cash, plant or other value, provided
FIXED AND FLOATING CAPITAL 15
capita]
always that the revenue account has been in the
meantime charged with adequate sums for expired
capital outlay.
In order to demonstrate the continuous shifting of JntTrdTa'ige"'
value taking place between the investments supposed aSHoStin"!
to represent fixed capital and the investments sup­posed
to represent floating capital, take the case of
a profit-seeking undertaking with a capital of ;^70,000
invested at the beginning of a period " N," in the
manner shown in the columns headed " Beginning " in
the pro forma balance sheet set out on p. 16. In this
case, it must be assumed that the profits have been
correctly computed during each part of the period,
the revenue account having been charged with
adequate sums for expired capital outlay. It must
also be assumed, for simplicity, that the accrued
profits have been distributed immediately prior to the
termination of the middle and end parts of the period
" N," except to the extent of ;^1,000, which was undis­tributed
; and, further, for the sake of simplicity, it
must be assumed that the wasting assets had no
remainder or scrap value. It is supposed that the
total depreciation for the period " N," amounting to
;£50,000, had been correctly forecasted and regularly
provided for, on a basis of equal distribution over
each part of the period as approximating most nearly
to the proportion in which the beneficial use of the
wasting assets, having a strictly limited economic life,
was obtainable for the service of revenue. The reasons
for the adoption of this basis of distribution of expired
capital outlay (depreciation), in dealing with industrial
plant and certain other descriptions of wasting assets,
are fully considered in later chapters.
16 DEPRECIATION AND WASTING ASSETS
BALANCE SHEET,
Showing position of Liabilities and Assets at
three different dates in the period " iV."
LIABILITIES.
CAPITAL—
'* Fixed "
" Floating " .
Debts payable
Undistributed
balance of
profit .
Begin­ning.
50,000
20,000
70,000
5,000
Middle.
£
35,000
35,000
70,000
5,000
1,000
End.
£
20,000
50,000
70,000
5,000
1,000
£75,000! £76,000 1 £76,000
ASSETS.
Wasting as­sets,
which
will all ex­pire
by the
end of poriod
" N "—
Lease of land
Buildings
Plant and
Machinery .
Ad d i t i 0 n a 1
plant pur­chased
later
and which
will not ex­pire
by the
end of pe­riod
" N " .
Other a s s e t s -
Sale stock .
Debts recei '-
able . .
Cash . . .
Begin­ning.
£
2,000
10,000
38,000
50,000
12,000
12,000
1,000
£75,000
Middle.
£
1,000
5,000
19,000
25,000
10,000
18,000
20,000
3,000
£76,000
End.
£
~
20,000
25,000
27,000
4,000
£76,000
At the beginning of the period, £50,000 of the
capital was invested in wasting assets, and would be
called fixed capital, and the remaining £20,000 was
employed in the form of other assets, and would be
called floating capital. By the middle of the period,
it will be seen on reference to the columns headed
" Middle," the unexpired value of the original wasting
assets has been reduced to ^^25,000, and, in order to
meet the requirements of a growing business during
that time, additional plant (wasting assets) has been
purchased, having then an unexpired value of £10,000 ;
and, further, the amount of floating capital required
FIXED AND FLOATING CAPITAL 17
has risen from £20,000 to £35,000, consisting of floating
assets, £41,000, less debts payable and undistributed
profits, £6,000.
The money used to pay for the additional plant
(wasting assets) purchased, and for the additional
floating capital required, is together the £25,000 which
has been gradually retained out of revenue to meet
the expired capital outlay on the original wasting assets.
The capital investment is thus upheld at £70,000,
although altered in character, and now consisting of
fixed capital £35,000, and floating capital £35,000.
If during this time the revenue account had been
charged with less than adequate sums for expired
capital outlay, the capital account would have been
robbed by revenue account to that extent, although
this fact would not be apparent, because the value
of the original wasting assets would stand overstated
to that extent in the balance sheet, the balance of the
floating capital assets being correspondingly reduced,
or the debts payable increased, by the amount impro­perly
paid away as dividend, assuming that this had
been done, as would be natural, because the profits
would have been overstated.
The position at the end of the period " N " is shown
in the columns headed " End " in the above balance
sheet. It is assumed that the business had by this
time increased to an extent requiring the use of addi­tional
plant (wasting assets), having a then unexpired
value of £20,000, and of additional floating capital of
£30,000. Both these requirements have in the mean­time
been financed out of the sums taken out of the
revenue receipts to answer the expired capital outlay
on the original wasting assets, which, at the end of
2—(1345)
18 DEPRECIATION AND WASTING ASSETS
the period, have fully expired in the sense of ceasing
to have any value or useful existence. The fact that
in actual practice this would not happen to all the
wasting assets simultaneously does not in any way
invalidate the principle which it is here sought to
illustrate.
At the end of the period the capital investment is
still fully upheld at £70,000, its original exchangeable
value ; but only £20,000 is at that time actually
invested in the form of fixed capital, the balance of
£50,000 being in the form of floating capital. It is
assumed that up to the last day of the period " N "
the manufactured out-turn of this increasing business
required the full and efficient use of the whole plant
and machinery, including that which originally cost
£38,000 (part of the £50,000 wasting assets), as well
as that represented by the additional plant purchased
during the period. The whole range of plant and
machinery, both original and additional, was thus
rendering efficient service up to the end of the period
(for otherwise it would have been scrapped at an
earlier date) ; but immediately after the end of the
period all the original plant was put out of service
and scrapped, and it is assumed that the lease and
efficient life of buildings also expired at the same
moment of time and required renewal.
In order, therefore, to carry on undiminished the
manufacturing and other operations of the business
as before, it will be necessary to have immediately
available new wasting assets (lease, buildings, and
plant), and for the sake of demonstration it may be
assumed that these again cost the original £50,000 to
purchase. On looking at the final position at the end
Il
FIXED AND FLOATING CAPITAL 19
of the period, as disclosed in the columns headed
" End" in the above balance sheet, it may seem
surprising to find that, although the expired capital
outlay (depreciation) has been regularly contributed
out of revenue receipts, there are no sufficient cash
resources available to enable the original wasting
assets to be renewed.
But, as has been shown in the case illustrated, the
^50,000 required for this purpose will now properly
be provided by an issue of new capital, which should
be made at a time prior to the end of period " N "
sufficient to allow of the renewal of the wasting assets
to be ready for service when required. The total
capital will then be £120,000, instead of ;^70,000,
consisting of fixed capital £70,000 and floating capital
£50,000. It is possible to observe, by reference to the
above balance sheet, the ebb and flow which takes
place between fixed and floating capital investments,
although the sum of the two should never be less than
the full amount of capital invested in the undertaking.
It has been assumed in the foregoing demonstration
that the extent of the business bond fide increased
during the period " N " from a figure represented by
seven to a figure represented by twelve, and it has
been shown that under these circumstances an increase
in capital from £70,000 to £120,000 was necessary and
proper, although the whole amount of such increase
was needed to renew wasting assets purchased out of
original capital. But the mere fact that the cash
resources of a business are found to be insufficient to
pay for the renewal of original plant or other wasting
assets when needed, even though, in the meantime,
without requiring the use of additional assets, the sales
20 DEPRECIATION AND WASTING ASSETS
or other receipts may have increased, by no means
proves that it is sound finance to make a new issue
of capital to provide the necessary money.
The shortage of cash resources may be due entirely
to the fact that revenue has in the meantime been
allowed to consume the capital invested in wasting
assets, without refunding to capital, out of the revenue
receipts, the value so consumed. The value consumed
would, in that case, have been inadvertently regarded
as part of the profits, and would probably have been
paid awaj' to shareholders as dividend, instead of
being retained, and—additional plant not having been
required—temporarily invested, to be available to
renew the original wasting assets or ultimately to pay
back the capital undiminished to shareholders.
Present How, thcn, are shareholders, directors, and managers
neglect to > ) o
^«?™t fo"^ to judge of the true financial position of an under-wJstiif^
assets taking from the balance sheet in each particular case ?
The state of such assets as sale stock, book debts, and
the like is always recorded in the accounts with
scrupulous care. Minute written particulars are avail­able
for inspection showing the original amount and
all the subsequent transactions concerning each unit,
both large and small. It is thus matter of common
knowledge that the " floating " part of the capital
investment, as existing from time to time, has been
adequately accounted for and entered in each annual
balance sheet at carefully settled values, based on the
known current conditions. But no detailed records
of the cost and present condition of investments, such
as buildings, plant, and machinery, and other wasting
assets, supposed to represent fixed capital, are, under
the present common practice, available for inspection
FIXED AND FLOATING CAPITAL 21
and consideration, and, therefore, it is impossible to
show a reasoned basis for, or to judge the sufficiency
of, the annual refunds (if any) which have been made
out of revenue receipts to capital to maintain the value
of this part of the capital investment unimpaired.
To enable any sound opinion to be formed as to the ^'"^ 'r""^"'
-J ^ quent
financial position of an undertaking, definite informa- oT?eEoMd''
tion, based on known facts and latest estimates, should [ n t S " °"
be available concerning the assets supposed to repre- Snto^^fng'™
sent fixed capital, just as it is now available concerning
the assets supposed to represent floating capital. But
as it is still customary to do without the aid of any
properly developed records relating to that part of the
capital investment represented by wasting assets, it
must be admitted that it is at present impossible to
form any reasoned judgment as to the true financial
position of any undertaking employing wasting
assets.
The^cause of this unsatisfactory state of affairs is 5;cèdS"''°"
to be found for the most part in the neglected con- „nguSs and
dition of that branch of annual accounting which calls '<==°™'^""^
for co-operation between engineers and accountants,
and which has to do with transactions combining fact
(known cost—save the case of an original owner
working a mass or source of natural raw material,
when the value must be estimated) and long-period
probability (unknown life and scrap value). It is true
that the amount of the provision for annual expired
capital outlay (depreciation) is small compared with
the enormous volume of other transactions involving
current receipt and payment of money, which are
accounted for with such scrupulous care and accuracy ;
but, nevertheless, this necessary provision often equals
24 DEPRECIATION AND WASTING ASSETS
Neglect of
present
accounting
tor past
capital outlay
unexpired
Depreciation
is as much
part of
Economic Cost
as are wages
paid
merged in pursuit of the particular object. If the sum
of exchangeable value produced during any period be
greater, there is a profit ; if it be less, there is a loss.
The words " cost," " expense," and " expenditure "
are generally taken to mean something which involves
an outlay of money at or about the present time, but
in the economic sense they mean the amount of value
consumed in securing the value produced.
It is clear, therefore, that cost incurred during any
period has no relation to the amount of value pur­chased
or paid for, but is the amount of value con­sumed
during that period. While it is true to say
that cost is generally regarded as being practically
confined to expenses involving present money outlay,
and that that part of cost is commonly carefully
recorded and adequately accounted for, it is equally
true to say that the other part of cost, relating to past
money outlay on wasting assets, the value of which
is being daily consumed in the course of carrying on
the business of an undertaking, has not hitherto been
considered as outlay which can be systematically
recorded and currently accounted for, and, therefore,
it receives little or no accounting attention.
It cannot by any means be denied that depreciation,
or expired capital outlay, is as much a part of economic
cost as is, for instance, the sum paid by the manu­facturer
for wages. The only difference between the
two classes of expense is that in one the money is paid,
or the exchangeable value outlaid in advance of its
use, the objective consideration being received there­fore
at a later date ; and, in the other, the considera­tion
(the man's work) is received first, and the money
paid immediately afterwards.
ECONOMIC COST 25
The necessity for treating expired capital outlay as ^^.^^^'j^^/^j,
part of economic cost has always been insisted upon
by economists; thus McCuUoch, on Political Economy,
says—
If the produce derived from an undertaking, after defraying
the necessary outlay, be insufficient to replace the capital
exhausted, a loss has been incurred; . . . if it is merely
sufficient . . . there is no annual profit.
The meaning of t h e words "capital e x h a u s t e d " used here
is evidently identical with the meaning of the words
" expired capital outlay." Again McCuUoch says—
Profits must not be confounded with the produce of industry
primarily received by the capitalist. They really consist of
the produce, or its value . . . after all necessary payments
have been deducted and after all the capital wasted and used
in the undertaking has been replaced.
In order to demonstrate this fact, suppose a
manufacturer purchased a lease of land, and built
and equipped a factory upon it, and carried on a
manufacturing business over a period " N," with the
result shown below—
REVENUE ACCOUNT FOR THE PERIOD " N."
Illustration of
Economic Cost
Capital outlay of
Money—•
Lease of Land .
Buildings .
Plant & Machinery
Current outlay of
Money, including
Materials, Labour,
and other expenses,
after paying all
debts payable .
Economic Cost .
Profit . . . .
Dr.
£
2,000
10,000
38,000
50,000
950.000
1,000,000
60,000
;É1,060,000
Current receipts of
money, after re­ceiving
all debts
receivable .
Cr.
i
;£1,060,000
;il,060,000
26 DEPRECIATION AND WASTING ASSETS
Difficulty in
computing
yearly
economic cost
Neglect to
refund expired
capita] outlay
out of annual
revenue
receipts
Suppose, at the end of the period " N," the lease
had expired, and the buildings and plant and machinery
were obsolete, and were taken over by the landlord
to cover the cost of removal and restoring the site
value of the land. In this case it is clear the manu­facturer
earned a profit over the period " N " of
^60,000 at a cost of £1,000,000.
But the difficulty in computing economic cost arises
largely from the fact that in practice it is necessary
to divide the period " N " into parts known as years,
and to estimate the profit which has accrued within
each of such years. The outlay on the lease, buildings,
plant, and machinery, amounting to ;£50,000, is paid
in advance out of capital, and called capital outlay
or capital expenditure, while the cost of materials,
labour, and other current expenses, amounting to
£950,000, is paid for out of current receipts spread
over the whole period " N."
Owing to the difficulty of estimating the proportion
of the £50,000 capital outlay which has expired within
each year of the period " N," it often happens, in
estimating the annual profits of an undertaking, that
no serious attempt is made to provide for that part
of the cost which consists of expired capital outlay.
It is sometimes ignored altogether until the value has
been used up, and in other cases provision is made in
a spasmodic and haphazard manner, without the
use of any regular scheme for annual measurement
based on properly recorded facts and latest estimates
of useful life periods made in accordance with the
current outlook. In the case stated, it might even
happen that, by the end of the period " N," the annual
profits h^ve been computed as artioupting to £110,000,,
ECONOMIC COST 27
and have been assessed to income tax and distributed
accordingly, entirely overlooking the fact that the
original £50,000 invested by the manufacturer has in
the meantime disappeared.
If the profits for the period " N " have been over-
^ -T statement of
computed at £110,000 instead of at £60,000, they annual profits
wiU have been overstated by no less than 83-3 per
cent. Assuming the period " N " to be twenty years,
the so computed profits would be equal to a dividend
of 11 per cent, per annum on a capital of £50,000—
omitting for simplicity working capital, which is not
always required—^whereas the actual profits are equal
to a dividend of 6 per cent, per annum on that sum.
If the undertaking is owned by shareholders, and ^i^^^tT^^f
is to be continued after the end of the period " N," '"^"'=' "P"^'
it is probable that during, or towards the end of, that
time, sums would have been set aside by the Directors
annually out of what would often be called " profits,"
and carried to the credit of an account called reserve
for renewals, or reserve for depreciation, and shortly
before the end of the period an invitation would have
been issued to shareholders to take up further Pre­ference
or Ordinary Shares to provide capital which
might be truly stated to be required to renew and
enlarge the factory. Suppose, under these circum­stances,
a sum of, say, £20,000 is standing to the
credit of the reserve account at the end of the period
" N," being the total of the sums set aside for depre­ciation
out of so-caUed " profits " during the period,
this amount will be available to go towards the cost
of rebuilding and equipping the new factory, provided
the money has not already been absorbed in the pur­chase
of additional fixed or floating capital assets.
28 DEPRECIATION AND WASTING ASSETS
And inflation
of share
capital
Ob"curity of
financial
position
as already described in the chapter on " Fixed and
Floating Capital."
And if the new equipment required for the under­taking
is now on a somewhat larger scale and costs
£60,000, instead of the original £50,000, to renew and
enlarge, the shareholders will have to add a further
£40,000, instead of £10,000, to their previous invest­ment
of £50,000 ; and the new factory equipment
and other wasting assets will then stand in the books
at £90,000, made up, as to £60,000, the actual cost,
and as to £30,000, the balance of expired capital out­lay
(depreciation) on the old factory equipment and
lease, which should have been charged to revenue
during the period " N." There can be no doubt that
this is the present condition of many industrial and
railway companies.
In the particular case stated, the position of affairs
would be clear enough to the directors and others
having access to the books, but in actual practice the
true financial position is always effectually obscured,
owing to the fact that the useful life of each class and
sub-division of wasting assets comes to an end at a
different time ; and as it becomes necessary to expend
money on the renewal of each of the many different
classes and sub-divisions as the end of the useful life
of each approaches, the cost of replacement is charged
to capital outlay as a matter of course, without any
means of first ascertaining whether all the original
cost has been duly charged to revenue. It is usual
to charge the whole of such renewal expense to capital
outlay in the case of those undertakings which make
a charge to revenue purporting to answer the unknown
cost of depreciation or expired capital outlay, although
ECONOMIC COST 29
the amount of this charge for depreciation is itself
often made dependent upon the success or otherwise
of each year's operations, and upon other considerations
turning on the financial convenience of the moment.
Whether economic cost is at present in many cases Need of
•*• *^ regular
largely understated, and if so to what extent this accounting
o J ' for capital
condition prevails, must be left to the determination """^^
of others ; but, however this may be, it is clear that
the entire absence of organisation and method in
recording and measuring expired capital outlay (depre­ciation)
is an undesirable state of affairs. In unknow­ing
or unscrupulous hands the financial evils arising
out of this condition of chaos can scarcely be over­stated,
and the time has arrived for the general adop­tion
and compulsory use of some suitable form of
recording equipment providing a flexible scheme of
measurement of annual expired capital outlay, based
on recorded facts and latest estimates of useful life
periods and scrap values, made from time to time and
kept up to date in accordance with the current out­look.
The compulsory use of a statutory register of
plant would leave all estimates and rates of depre­ciation
in the absolute discretion of those responsible
for the undertaking, and they would not, under any
circumstances, be penalised for errors of judgment.
A study of the subject will show that this is quite of'thfs"""'^^^
practicable, and that the administrators of any kind Hs'^^st"'^""'
of enterprise may, by taking thought, develop and
adapt a suitable scheme, which may be regularly used
year by year with great advantage, at a cost infini­tesimal
compared with its value. It is a problem
affecting almost all industries and trades, which would
well repay wdde and organised scientific research ; and
30 DEPRECIATION AND WASTING ASSETS
it should have the special attention of scientific
institutions, technical colleges, universities, and other
bodies interested in the advancement of practical
science.
Payment of It will be convcnicnt here to call attention to the
company
noVïwa's' ^^^^ *^^* ^^^ payment of dividends by joint stock
to'amount oT" compaiiies is not in all cases limited by English law
profits |.Q |.j^g amount of economic profit earned. The legal
position is clearly stated in Buckley on the Companies
Acts (ninth edition), where, in discussing Article 97
of Table " A " of the Companies (Consolidation) Act,
1908, which provides that " no dividend shall be paid
otherwise than out of profits," it is stated—
The profits of the business are the excess of revenue receipts
over expenses properly chargeable to revenue account. As to
what expenses are properly chargeable to capital and what
to revenue, it is necessarily impossible to lay down any general
rule. For the purpose of ascertaining profit available for
dividend, capital account and revenue account are to be
treated as separate accounts.
These principles, when rightly understood, are not
antagonistic to the economic facts discussed in this
chapter if the word " expenses " be read as meaning
" cost." It has been already shown that the capital
investment, in some form, must be maintained unim­paired,
and so kept separate from revenue in the
sense of being kept intact. But the portions of such
assets as cash at bank, debts, or stock, which may
for the time being represent part of the capital invest­ment,
cannot be earmarked and recorded in a separate
account as capital.
Legal decision, The dccislons in the following amongst other
Lee V. yj KJ
Neuchatfi interesting cases are quoted in Buckley on the
Companies Acts (ninth edition)—
KCONOMIC COST 31
In Lee v. Neuchaiel Company (41 Ch. Div. 1) it was held
that if the objects of the Company include the sinking of
capital in the acquisition of wasting property, even deprecia­tion
by waste is not necessarily a revenue charge, but may
by the regulations be thrown upon capital. . . . If the
memorandum of association provides that the object of the
Company shall be to sink its capital in a wasting property
and acquire profit by working that property, then the gradual
diminution of the property by waste is a gradual destruction
of the Company's capital, which may be within its objects
legitimate . . . it is for the shareholders to say whether or
not they will put by a sinking fund to meet the waste, and
the proper place to find this is in the Articles. They may
if they like, but they are not bound so to provide.
In Lambert v. Neuchaiel Asphalie Company [1882] W.M. 128:
30 W.R. 913, it was held that the Articles had given a
general meeting power to declare what were net profits, and
that the Court could not assume jurisdiction to determine it.
Sir Henry Buckley states—
The fact is that the law is much more accurately expressed
by saying that dividends cannot be paid out of capital than
by saying that they can only be paid out of profits. The
latter expression leads to the inference that the capital must
always be kept up and be represented by assets, which if sold
would produce it. This is more than the law requires.
Fixed capital may be sunk and lost, and yet the excess of
current receipts over current payments may be divided.
But floating or circulating capital must be kept up, as other­wise
it will enter into and form part of such excess (seeing
that circulating capital, with the particulars of its purchase
and sale, must appear in revenue account), in which case
to divide such excess without deducting the capital which
forms part of it will be contrary to law.
(Per Lindley, L.J.: Venier v. Gen. Trust [1894], 2 Ch. 266.)
It may be said with equal truth that fixed capital
should be kept up, as otherwise it will enter into and
form part of the excess, for the particulars of its sale
are equally included as part of the sales appearing in
the revenue account, but the particulars of its cost—
that is, the properly measured charge for expired
Legal decision,
Lambert V,
Nettchatel
Asphalie
Company
Legal dicta
Lfgal doctrine
protects
commercial
practice
32 DEPRECIATION AND WASTING ASSETS
capital outlay (depreciation)—are often omitted alto­gether
from the revenue account. The legal doctrine
as to the difference in the treatment of the fixed and
floating assets, when the declared object of the Com­pany
is to sink its capital in wasting assets (called
fixed capital), is doubtless necessary in order to pro­tect
the present common commercial practice in the
treatment of the accounts of collieries, mines, and
other similar undertakings, where no serious attempt
is made to ascertain and charge to the annual revenue
account a proportionate part of the original cost of
the diminishing mass of raw material. Thus the
surplus balance of the annual revenue account, which
is generally regarded as profit and distributed as divi­dend,
includes, and may sometimes wholly consist of,
exhausted capital outlay which has not been provided
for out of revenue.
Directors are The law thus allows Considerable latitude when the
bound to
make proper dcclarcd obicct of an undertaking is to sink its capital
investigation ^ o r
in wasting assets ; yet directors are bound to make
proper investigation before recommending the declara­tion
of a dividend, and Sir Henry Buckley further
states—
But if a dividend be declared without proper investigation
of the financial position of the Company . . . the burden
is on the directors to show that the dividend was properly
declared, and in default a director will be ordered to refund
the dividend he has received {Ranee's case, 6 Ch. 104); and
if directors pay dividends out of capital, they may be liable
for the whole amount so misapplied {National Funds Com­pany,
10 Ch.D. 118; Oxford Building Society, 35 Ch.D. 502;
Leeds Estate Company v. Shepherd, 36 Ch.D. 787).
CHAPTER V
THE INTEREST QUESTION
THE interest question in connection with depreciation interest
^ '• question
and wasting assets deserves careful consideration, and f^^^t^ntto^
some preliminary remarks on the nature of interest
may be convenient.
In theory, interest is always accruing on principal, Nature oj
the sum of which is always increasing by the accruing " '^^^
interest ; but in commercial practice some definite
period, or rest, is adopted, at the end of which period
interest at the agreed rate is computed on the
principal sum outstanding at the beginning of that
period, and the amount of such interest is then either
immediately paid off in cash or forthwith added to
the principal sum upon which interest wül next be
computed, and so on. In commercial practice, there­fore,
interest remains unproductive until it is com­puted
at the end of each period. It is thus really in
the nature of a periodical rent, charged by a lender
to a borrower, for the use of money.
The periods or rests may be of any length, but they importance
usually cover three, six, or twelve calendar months, periods or
•' rests
Commercial interest is commonly described as being
at a stated rate per cent, per annum, but if the rests
used cover periods either shorter or longer than one
year, the expression is inaccurate unless qualified by
the further words " payable quarterly " or " payable
half-yearly." Thus, with half-yearly rests, interest is
often described without quahfication as being at a
rate of, for instance, 5 per cent, per annum when it is,
33
3—<I345)
34 DEPRECIATION AND WASTING ASSETS
Definitions of
interest.
Commercial
compound
interest
Proper use of
interest
in fact, a rate of 2^ per cent, per half-year, and greater
than a rate of 5 per cent, per annum, and with rests
extending over two years it is less than a rate of 5 per
cent, per annum. The reason is, of course, that from
the time interest is either paid to the lender or added
to the principal sum, it acquires productive power
itself, so that if the time recurs other than once a year
it varies the consideration and thus the effective rate
of interest passing to the lender. This fact may
assume importance where, for instance, debenture or
preference stockholders are entitled to a share of the
profits of an undertaking limited simply to a stated
rate per cent, per annum on the par value of their
holdings.
Interest has been variously defined as money paid
for the use of money lent, or for forbearance of a debt
according to a fixed ratio (rate per cent.), and it is
also said that interest is the increase of an indebted­ness
by reason of the lapse of time, and that interest
is possible only in case of the existence of a debt.
Compound interest is interest upon interest, and in
commercial practice it operates when an amount of
interest, computed at the end of any period, is added
to the principal sum, instead of being paid off in cash.
Interest may be compounded in this way, either
quarterly, half-yearly, yearly, or otherwise, according
to the length of the period or rest used in each case,
and it is then described, in commercial practice, as
compound interest.
As a general rule, in computing the profit or loss
of an undertaking, interest should only be employed
in commercial accounts when it is actually payable
or actually receivable as interest. The amount of the
THE INTEREST QUESTION 35
profit or loss of an undertaking is itself the interest
(increment) or discount (decrement) resulting from
the capital employed. On the other hand, in com­puting
the cost (as distinct from profit or loss) of
producing commodities or other values, or of rendering
public or private services, interest at a suitable rate
on the capital employed is an important part of cost,
and in computing annual cost must always be pro­perly
distributed as " Interest on Capital." Interest
is, however, often used in commercial accounts in
other ways, with results which are not always apparent,
as will be seen from the illustrations set out below.
There are certain theoretical methods of making 4™^d''of
provision for expired capital outlay (depreciation) de^ecSn
which involve the use of interest : one known as the
annuity method, in which revenue is charged, under
the head of depreciation, with equal annual sums
sufficient to provide at the expiration of the estimated
life of, for instance, industrial plant, an amount equal
to the original cost thereof, plus interest on the capital
for the time being remaining invested therein. An
amount equal to that part of these annual sums
which represents interest is credited, in annually
diminishing amounts, to the revenue account, so that,
taking the difference between the constant amount
debited for depreciation and the diminishing amount
credited to revenue each year as interest, the result
is really to throw increasing annual burdens upon the
revenue account as the industrial plant gets nearer
to the end of its life.
The effect of this method will be clearer by taking illustration of
an imaginary case, in which industrial plant, having mcTod
an estimated life of ten years, and no residual value.
Tij'iiili IÏ .'.
36 DEPRECIATION AND WASTING ASSETS
has cost ;£6,000 and is to be written off within that
period on the annuity system, charging interest at
3 per cent, per annum upon the diminishing balances.
In this case, the constant annual sums chargeable to
revenue for expired capital outlay would amount to
a total, during the ten years, of £7,033 16s. 8d., and
the diminishing sums which would be credited to
revenue in respect of interest amount to a total of
£1.033 16s. 8d.
The figures are shown below—
1st year . .
2nd ,,
3rd
4th
5th
6th
7th
8th
9th
10th
TOTAL . .
Expired capital
outlay charged to
Revenue.
£ s. d.
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
;^7,033 16 8
Interest
credited to
Revenue.
£ s-
180 0
164 6
148 2
131 9
114 6
96 12
78 8
59 13
40 7
20 9
;él,033 16
d.
0
0
7
5
3
9
8
9
6
9
8
Actual burden
on the year.
£ s. d.
523 7 8
539 1 8
555 5 1
571 18 3
589 1 5
606 14 11
624 19 0
643 13 11
663 0 2
682 17 11
IQfim 0 0
Thus the charging or debiting of interest to that
part of the capital investment represented by industrial
plant, and the crediting of this as interest to revenue,
creates the necessity, as shown above, of debiting
revenue with a correspondingly larger sum under the
head of depreciation, and writing off this larger amount
from the capital investment to offset the interest
charged thereto, the operation resulting in an unfair
annual distribution of the depreciation charge.
ÏHË INTEREST QUESTION 37
Another method of providing for depreciation ^^'J'^^l^™*^
involving the use of interest is that known as the ^'^;,°P^?^?i|^
sinking fund method ; and to make the effect of this
clearer a case may again be taken of a purchase of
industrial plant which cost £6,000 and has a life of
ten years, and no residual value, where the sinking
fund method is to be applied, involving yearly instal­ments
being taken out of the business and invested
in outside securities, yielding, say, 3 per cent. Here
the equal annual sums charged to the revenue amount
to ;£523 7s. 8d., or a total for the ten years of
£5,233 16s. 8d., and the total interest earned on the
investments in securities outside the business amounts
to £766 3s. 4d., being altogether £6,000.
The figures are as follows— illustration of
sinking fund
^ . method
1st year
2nd „
3rd
4th
5th
6th
7th
8th
9th
10th
TOTAL
Expired capital
outlay charged to
Revenue.
i s. d.
523 7 8
523 7 8
523 7 8
523 7 8
523 7 8
523 7 8
523 7 8
523 7 8
523 7 8
523 7 8
;^5,233 16 8
Interest
from
Investments.
£ s. d.
15 14 0
31 17 5
48 10 7
65 13 9
83 7 3
101 11 4
120 6 3
139 12 6
159 10 3
£]&& 3 4
Actual
burden on the
year.
£ 5. d.
523 7 8
539 1 8
555 5 1
571 18 3
589 1 5
606 14 11
624 19 0
643 13 U
663 0 2
682 17 11
;^6,000 0 0
1
By this method, £766 3s. 4d., the total of the
annually increasing interest from the investment of
the money gradually released from the original cost
of the industrial plant, is diverted from the credit of
the revenue account, where it ought to appear, and
38 DEPRECIATION AND WASTING ASSETS
is appHed direct to the purpose of helping to accumu­late,
by the end of the economic life of the industrial
plant, the sum of £6,000 (original cost), revenue
account having in the meantime been charged with a
less sum by £766 3s. 4d. than the actual provision
which was made by the aid of this method ; so that
the true effect is an omission from both sides of the
revenue account, under the heads of depreciation on
the one side and of interest on the other side, of
annually increasing sums amounting during the ten
years to £766 3s. 4d.
If a record of these so omitted annually increasing
sums is introduced to both sides of the revenue account,
it will be found that the sinking fund method has
exactly the same effect as the annuity method, for in
both cases the actual burden upon revenue for the
first year of the ten is £523 7s. 8d., and this increases
until, for the last year of the ten, it is £682 17s. lid.
It must be remembered that in the sinking fund
method the interest from investments is reaUy received,
whereas in the annuity method it is a mere fictitious
entry, and, therefore, in order to get back to facts,
must be cancelled by deducting it each year from the
amount charged as depreciation on the debit side of
the revenue account.
Comparison If a comparison is made between the total sum of
annuuy^and £7,033 16s. 8d. charged as depreciation during the ten
methods years to the revenue account under the annuity method,
and the total sum of £5,233 16s. 8d. charged in like
manner during the same period under the sinking fund
method, it will be found that the difference of £1,800
represents a sum equal to 3 per cent, for the whole
period of ten years on the £6,000 originally paid for
THE INTEREST QUESTION 39
the industrial plant; and thus the first-named method
operates to add £1,033 16s. 8d. to the true amount
of expired capital outlay (depreciation), and the last-named
method operates to deduct £766 3s. 4d. from
the true amount of this.
In a going concern, having the use of a definite ^^ï-g'^g
capital, the charging of imaginary interest on that capuaromiay
part of the capital investment represented from time ™' ™'er«st
to time by the unexpired capital outlay on wasting
assets is nothing more than a transfer of the amount
of such interest from one nominal account to another,
which has very little ultimate effect, although it varies
the distribution of the annual profit over the series
of years. It is reaUy a manipulation of certain heads
of capital outlay and certain heads of annual revenue,
within the undertaking itself, which, as between one
year and another, has important effects on the balances
of the capital outlay and revenue accounts respectively,
but dqes not vary the sum of the annual computations
of profit or loss extending over the whole-life period,
except to the extent of a small difference in the annual
earning power of the money retained out of revenue
receipts each year, caused by the difference in the rate
of its annual accumulation. This wiU be made clear
by an examination of the following illustration.
Suppose a case in which a sum of £6,000 is invested JUJf^g^""" °'
in industrial plant having a life of ten years, and
suppose the amounts of the sales and current expenses
are constant in each of the ten years, the sales of the
product of the industrial plant bringing in £13,000
per annum, and the current purchases of raw material,
wages, and other expenses amounting to £12,000 per
annum, leaving, therefore, £1,000 per annum to answer
40 DEPRECIATION AND WASTING ASSETS
expired capital outlay (depreciation) and profit. The
following figures show the difference in the revenue
results as between one year and another—(a) chargirg
interest at 3 per cent, on the capital investment,
known as the annuity method; and (&) omitting
interest on the capital investment. In both cases,
the results are equal over the whole-life period, and
show a profit of £4,000—
1st year .
2nd „
3rd „ .
4th „ .
5th „ .
6th „
7th „ .
8th „
9th „
loth „
Charging interest at 3 per cent.
Expired
capital out­lay
charged
to revenue.
£ s. d.
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
703 7 8
£7,033 16 8
Interest
credited to
revenue.
{. s. d.
180 0 0
164 6 0
148 2 7
131 9 5
114 6 3
96 12 9
78 8 8
59 13 9
40 7 6
20 9 9
£1,033 16 8
Resulting
annual
burden on
revenue.
£ s. d.
523 7 8
539 I 8
555 5 I
571 18 3
589 I 5
606 14 II
624 19 0
643 13 11
663 0 2
682 17 II
£6,000 0 0
Resulting
annual
profit.
£ s. d.
476 12 4
460 18 4
444 14 II
428 I 9
410 18 7
393 5 I
375 I 0
356 6 I
336 19 10
317 2 I
i4,000 0 0
Omitting int.
Expired
capital
outlay
charged
to
revenue.
£
600
600
600
600
600
600
600
600
600
600
£6,000
Result­ing
annual
profit.
£
400
400
400
400
400
400
400
400
400
400
£4,000
In this case it is assumed that the industrial plant
has done its work efficiently during the whole of its
efiicient life, and on the stated facts the true economic
profit of the first year is ;£400 and not £476 12s. 4d.,
and of the last year it is again £400 and not £317 2s. Id.,
because there is, in fact, no interest earned and it is
not permissible to appropriate in advance in the name
of interest sums on account of profit expected to be
earned from the use of the plant in future years.
The accumulated portion of the £6,000 which has
been released to the end of each year under each of
these two methods varies, and is shown below; and
THE INTEREST QUESTION 41
a column is added in each case showing simple interest
at 3 per cent, per annum on the accumulated amount
so released, as being the minimum earning power of
this money to the undertaking for use in other ways.
This table is inserted expressly to show approximately
the extent of the difference in the annual earning power
of the varying amounts of money retained out of
revenue receipts each year under each of the two
methods—
ist year
2nd ,,
3rd „
4th „ .
5th „
6th „
7th „
8th „
9th „
loth „
Charging interest at
3 per ct
Accumulated
portion of
£6,000 released
(see Note
below).
£ s. d.
261 13 10
792 18 5
1,340 I 10
1,903 13 6
2,484 3 4
3,082 I 6
3,697 18 6
4,332 4 II
4,985 12 0
5,658 II 0
nt.
Earning
power
at 3 per cent.
per annum.
£ s. d-
7 17 0
23 15 9
40 4 0
57 a 2
74 10 6
92 9 3
n o iS 6
129 19 4
149 I I 4
169 15 I
£856 2 II
Difference
in annual
earning
power of
accumulated
portion
released.
£ s. d.
I 3 0
3 4 3
4 16 0
5 17 10
6 9 6
6 10 9
6 I 6
5 0 8
3 8 8
I 4 II
£43 17 I
Omitting interest.
Accumu*
lated
portion of
£6,000 re­leased
{see
Note below).
£
300
900
1,500
2,100
2,700
3.300
3,900
4.500
5,100
5,700
Earning
power at
3 per cent.
per annum.
£
9
27
45
63
81
99
117
133
153
171
£900
NOTE.—^The amounts appearing in the columns headed " Accumulated portion of
£6,000 released " allow for the fact that each periodical contribution accrued continuously
over each period and not in one sum at the end of each period.
In the case of a going concern using a definite in commercial
^ ^ " accountmg,
capital, the moneys retained out of revenue to answer „ofbe*;.^^"]^
expired capital outlay on wasting assets (depreciation) ™cted'up in
are, as a rule, immediately requisitioned either to ^^t'^s assets
purchase other wasting assets, thereby maintaining
the volume of the " fixed " capital investment, or for
use in some other form as part of the " floating "
capital investment, as explained in the chapter on
" Fixed and Floating Capital." If, however, the
42 DEPRECIATION AND WASTING ASSETS
moneys are not required for either of these purposes,
they will, doubtless, be temporarily invested in income-yielding
securities, so that in any case they remain
productive of income to the undertaking. Nothing
is gained by debiting the wasting assets account and
crediting revenue with imaginary interest on the
moneys remaining locked up in these wasting assets,
which cannot earn interest. There is no good reason
for charging this part of the capital investment with
interest and exonerating the other part. If interest
is charged on the moneys locked up in investments
such as wasting assets, supposed to represent fixed
capital, it should surely also be charged on the moneys
locked up in investments such as sale stock and debts,
supposed to represent floating capital.
But interest is The f allacv of incorporating in commercial accounts,
an important ,j ± KJ
com°utrn prepared with the object of ascertaining annual profit
production o^ ^oss, interest on the money locked up in wasting
assets may have originated in questions of the com­parative
cost of different methods of producing com­modities
and rendering public services. Thus, in
comparing the relative advantage of a method of
production necessitating the use of expensive machinery,
with a method of production by hand labour, it is
necessary to have regard to all the factors of cost,
including, in the case of the method involving the use
of machinery, both expired capital outlay (deprecia­tion)
and interest on the capital outlay. In aU ques­tions
concerning the determination of cost for com­petitive
or for comparative purposes, therefore, interest
on the amount of capital outlay must always be
included as part of the cost; and, as more fuUy
explained later, in computing annual cost for this
THE INTEREST QUESTION 43
purpose, in the case of an undertaking to be treated
as terminating at the end of the life of certain long-lived
wasting assets which are not to be renewed,
care should be taken that the sum of the whole-life
period interest is evenly distributed over each year
on the principle of average, as otherwise the annual
cost, for the purpose of comparison with outside con­tractors'
charges, will be overstated in the earlier
years and understated in the later years of the period.
Another cause which may have led to the practice Diminution in
•^ * capital locked
of charging, and incorporating in commercial accounts, Xnt'Soël nm
interest on the money remaining locked up in wasting ^^"jnt OT"""
assets—such as an electric power station, for instance, tfe'^piaS "'
which cost when new £100,000, and has an average
life of twenty-five years—may be the mistaken impres­sion
that the annual instalments of the original cost,
taken back out of each year's gross revenue, which
diminish the amount of capital locked up, also in some
way diminish the extent of the industrial plant offered
for the use of the undertaking in the later years of
the life period; and that, therefore, these later years
should be charged with a gradually diminishing sum.
But this is not so, for until the industrial plant becomes
worn out or obsolete, which cannot be during its
efficient life, each unit most do its work well, and be
able to give an output not seriously diverging from
the highest of which it is capable in a state of com­plete
efficiency ; and during the whole life of the
industrial plant forming the equipment of this electric
power station the quantity of plant remains the same
as it was at the beginning of the period, for the short-hved
classes will be duly renewed from time to time.
Doubtless there is some faUing-off in the efficiency of
44 OEPRECtATlON AND WASTING ASSETS
individual units as they approach the ends of their
life periods, but the effect of this is equahsed by the
operation of the law of average, and obviously each
unit must render not less than efficient service during
the whole of its efficient life.
Sd sfnklSg'"' Government departments and municipalities often
by"'L'ÏSïcipt!- undertake the manufacture and supply of com-
"'^^ modifies, such as gas, water, electrical energy, and
the like, and also the provision of public services, such
as transport, telephones, etc., involving a large initial
outlay of capital, which may be subscribed by indi­vidual
members of the public or provided out of public
moneys. The nature of the arrangements made for
financing these undertakings varies considerably ; but
annuity or sinking fund methods, involving the use
of interest, are often adopted, the annual instalments
being sometimes brought into revenue account in lieu
of properly measured charges for depreciation in a way
which may cause the balances of the annual revenue
accounts to vary considerably from the true annual
profit or loss of the undertaking. It is thus most
important that the effect of these financial arrange­ments
on the annual accounts should be clearly under­stood,
to ensure that the accounts are correctly treated,
and any necessary further provisions made, as it will
be found that instalments of principal and interest are
dangerous sums to handle as alternatives to properly
measured charges for depreciation when it is desired
to ascertain either true annual cost or true annual
profit or loss of an undertaking.
Computation In vlcw of the fact that it is sometimes necessary
of annual cost -^
i'ting*''™'"' ^° compute the annual cost, apart from profit or loss,
undertaking ^f Carrying on an undertaking terminating at the end
THE INTEREST QUESTION 45
of the life of certain long-lived wasting assets which
are not to be renewed, it wiU be worth while to con­sider
how, for the purpose of ascertaining annual cost,
that part of the cost represented by interest on the
capital employed should be distributed over each year.
When the long-lived industrial plant needed for an
undertaking of this kind is new, the amount of capital
locked up therein is greater than it is in the later
years of the period, and in ascertaining the annual
cost, therefore, for the purpose of comparison with
outside contractors' charges (assuming that con­tractors'
undertakings are permanent and need an
average capital outlay), it will be misleading for this
purpose to charge the earlier years with the interest
on the larger amounts of capital then locked up in
the industrial plant as part of the cost of those earher
years, and to charge the later years of the period
with interest on the then comparatively small amounts
of capital remaining invested at thaf time.
The obiect is, of course, to compare the cost of interest shouw
•^ -^ in such cases
production of commodities or supply of services by be charged on
^ -Lr ./ J average
a public authority with the average cost at which '=*?"*'
similar work might be performed by outside con­tractors
under ordinary outside conditions, and,
therefore, it is necessary to bear in mind in this con­nection
that the industrial plant of outside con­tractors
is " aged," that is to say, has reached, and is
presumably maintained in, a state of average efficiency
such as would be needed for the purposes of a
continuously going concern. Thus the outside con­tractors'
cost is burdened only with interest on the
average capital employed, and therefore for com­parative
purposes the annual cost of operating a
4 6 DEPRECIATION AND WASTING ASSETS
terminating undertaking should be charged with
annual interest on the same average basis.
In order to illustrate the method of arriving at the
average capital employed in carrying on an under­taking
which is to be treated as terminating at the
end of the life of long-lived wasting assets, it will be
convenient to assume, for the purpose of demonstra­tion,
a period of ten years instead of a longer period,
and to consider the case of an electric power station
involving an initial outlay of capital of, say, £75,000,
made up as under—
Life period permanent
„ 1 year
„ 2 years
4 „
5 „
10 „
For the sake of simplicity, scrap value of the plant
is omitted.
It is required to ascertain the average amount of
capital remaining invested in this undertaking over
the whole period of ten years. The capital locked
up in the land, ;£25,000, will remain the same through­out
the period, for it does not waste ; and, as already
explained in the earlier chapters, any fluctuations in
its market value during the period must be disregarded.
In order to follow in detail the ebb and flow of the
volume of capital locked up during the assumed life
period (ten years) in the several classes of plant, with
different efficient life periods, reference may be made
to the tabular statement set out below, which contains
a column for each class of plant, showing the
Illustration of
method of
arriving at
average
capital
Land ;£25,000
Plant A ;^10,000
„ B ;£10,000
„ C ;ilO,000
„ D ;£10,000
., E ;ilO,000
;£75,000
THE INTEREST QUESTION 47
fluctuating amount of capital invested therein at the
beginning of each of the ten years—
STATEMENT
Showing Amount of Capital locked up in each class of
Plant at the beginning of each of the ten years.
Begin­ning
of
year.
1
2
3
4
5
6
7
8
9
10
A
Life I year.
i
10,000-^ 1
10,000-^ 1
10,000-^ 1
10,000-^ 1
10,000-r 1
10,000-r 1
10,000-f 1
10,000-=- 1
10,000-^ 1
10,000^ 1
B
Life 2 years.
10,000
5,000
15,000-f 2
10,000
5,000
15,000-r 2
10,000
5,000
15,000-f 2
10,000
5,000
15,000-=- 2
10,000
5,000
15,000-=-2
c
Life 4 years.
£
10,000
7,500
5,000
2,500
25,000-=- 4
10,000
7,500
5,000
2,500
25,000-=- 4
10,000
7,500
D
Life 5 years.
£
10,000
8,000
6,000
4,000
2,000
30,000-=- 5
10,000
8,000
6,000
4,000
2,000
30,000-=- 5
E
Life lo years.
£
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
55,000-^ 10
Uncorrected average capital locked up during the
period—
10,000-=- 1
- 10,000
£
15,000-=- 2
= 7,500
£ I £
25,000 -=- 4 30,000 -^ 5
= 6,250 I = 6,000
55,000-=- 10
= 5,500
48 DEPRECIATION AND WASTING ASSETS
In the above computations of average capital
remaining invested in each of the different classes of
plant, it will be observed that the annual contribution
has been deducted at the end of each year ; whereas,
in order to obtain the true average, due allowance
must be made for the fact that each annual contribu­tion
accrues continuously during each year, and not
in one sum at the end of each year; and, therefore,
the average capital employed in the undertaking
is (subject to the reservation set out in the next
paragraph) ascertained in the following manner—
Land .
Plant A .
„ B. .
„ C. .
„ D. .
„ E. .
Un­corrected
Average.
I
25,000
10,000
7,500
6,250
6,000
5,500
minus half of £10,000, being one
year's contribution
;i5,000.
A500,
Aooo,
;£1,000,
Average capital
Corrected
Average.
I
25,000
5,000
5,000
5,000
5,000
5,000
;£50,000
Short method jn the case illustrated above, however, it will be
of arriving at
cIpUaT noticed that the efficient life periods of the several
classes of plant do not all terminate at the end of the
assumed period of ten years, being the period covered
by the useful existence of the longest-lived class of
plant. The case has been stated and set out in this
form in order to call special attention to the fact
that in dealing with an undertaking to be treated as
terminating at the end of a certain period it is desir­able
that the efficient life periods of all the several
classes of industrial plant shall be so planned as to
THE INTEREST QUESTION 49
end as nearly as possible at the same time, to avoid
a loss on forced realisation of any unexpired capital
outlay, which in the case illustrated would be ;^5,000,
the computed value of two years' unexhausted work­ing
capacity remaining in Plant C at the end of the
ten years. Assuming the efficient life periods of the
different classes of plant will all terminate about the
same time, the short method of ascertaining the
average capital employed in a terminating undertaking
is to divide by two the amount of the original capital
invested in wasting assets, and add thereto the amount
of capital invested in land, which remains permanent
throughout the whole period.
Although as a general rule interest should only be use of interest
° ° •'in dealing
employed in commercial accounting when it is actually J^^''^'=°|' °'
payable or actually receivable as interest, there may v^^'^'^<'^
be exceptional cases in which its use is desirable, as,
for instance, in dealing with the cost of leasehold
premises, when it is sought to charge the revenue
account with a sum to represent the annual value of
premises occupied for trade as a basis for comparison
with other similar undertakings paying an annual
rental. In such a case, the use of the annuity method
in writing off the annual instalments of the cost of
leasehold premises may be convenient. Supposing
a short lease to have cost ;£6,000, and to cover a
period of ten years, it will be seen by reference to
page 36 that, with interest at 3 per cent, per annum,
the annuity method will involve an annual charge to
revenue of ;^703 7s. 8d., which is, no doubt, nearer
to the true annual value of the premises than the
;^600 to be charged if the plan of writing off one-tenth
of the cost each year were adopted. Under this
4—(1345)
50 DEPRECIATION AKD WASTING ASSETS
annuity method, interest is credited in annually
diminishing amounts to the revenue account, and
represents the gradually diminishing alternative profit
which would have been earned by the money invested
in the leasehold premises if it had been otherwise
employed for the purposes of the business, and the
premises had been held on an annual, instead of on
a leasehold, tenancy.
Summary of jo sum UD the interest question, it is submitted that—
conclusions ^ T. '
(a) The amount of the profit or loss of an undertaking is
itself the interest (increment) or discount (decrement) resulting
from the capital employed.
(è) In computing the annual profit or loss of an under­taking,
therefore, interest should only be employed in com­mercial
accounts when it is actually payable or actually
receivable as interest.
(c) Annuity and sinking fund methods involving the use
of interest should never be used in measuring annual expired
capital outlay (depreciation) on wasting assets, unless some
special reason exists.
(d) In computing cost of production, as distinct from profit
or loss, interest on the capital employed must be included
as part of the cost.
(e) In computing annual cost of production for compara­tive
purposes in the case of an undertaking to be treated as
terminating at the end of the life of long-lived wasting assets
which are not to be renewed, the interest should be evenly
distributed over the period on the principle of average.
Further arguments against the use of annual interest,
or annual discount, in commercial accounting, unless
actually payable or actually receivable by the owners
of an undertaking, may be stated thus—
The argument that the capital locked up in such assets as
industrial plant, leasehold property, or purchased terminable
concessions must be charged, in the accounts of a commercial
undertaking, with interest, because it might otherwise have
been invested to produce interest, has no force. It might
as well be applied to the capital locked up in the other assets
of a business over long and varying periods of time, such as
goodwill, patent rights, stock-in-trade, and book debts; but
Further
arguments
against the use
of interest or
discount in
commercial
accounting
unless actually
payable or
actually
receivable '\
THE INTEREST QUESTION 51
it is never suggested that assets of this kind should be
subjected to interest or discount in commercial accounting.
The capital of an undertaking is provided expressly to be
locked up in carrying out all and any of the legitimate trans­actions
of the business. All transactions involve the use of
more or less capital for some period of time; and, if the cost
of some transactions is to be increased by adding to it
imaginary annual interest on the capital locked up, then
surely interest should be added to the cost of all transactions,
whether extending to more or less than a year, which,
obviously, would be absurd. In commercial accounting, no
attempt should be made by manipulating interest to reduce
the results of certain selected long-period transactions to the
basis of annual transactions.
Any long-period transaction which is essentially in the
nature of a loan, calculated with annual interest, as in the
case of a purchased terminable annuity, should be treated
as such in the accounts of a commercial undertaking; thus,
each equal annual payment of an annuity contains both
interest and capital, but in each annual payment after the
first the proportion of interest becomes less, and the proportion
of capital becomes correspondingly greater.
As shown in the illustrations of the effect of the annuity
and sinking fund methods already given in this chapter, the
use of the annuity method for providing annual depreciation
operates to add to the true depreciation a fictitious sum
(interest), this fictitious sum being, on the other hand,
credited to the revenue accounts as interest (though it is not
received) in annually decreasing amounts, the net result of
these entries being to place an increasing burden of depreciation
on the annual revenue accounts.
And the use of the sinking fund method for providing
annual depreciation operates to deduct from the true depre­ciation
a sum equal to the dividends which will be received
from outside securities in which the annual sinking fund
instalments will be invested. These dividends, being actually
received, are true revenue of the undertaking, and should
appear to the credit of the revenue accounts as received in
annually increasing sums, involving, on the other hand, a
similar annually increasing further charge to the revenue
accounts under the head of depreciation, the net result being
again to place an increasing burden of depreciation on the
annual revenue accounts.
In the case of a long-period transaction entered into by a
private individual, as, for instance, the purchase of a lease,
it may be convenient to charge the transaction with annual
interest on the capital remaining from time to time invested
52 DEPRECIATION AND WASTING ASSETS
therein, by the use of the annuity method of writing off the
cost. The transaction does not form part of a business
having a definite amount of capital subscribed for the pur­pose
of seeking profits by carrying out a number of
transactions, of which the purchase of a lease may be one.
Thus the indi