DEPRECIATION AND RATE CONTROL

A CRITICISM

In a recent article in this Journal Professor Allyn A. Young takes to task the United States Supreme Court and public service commissions generally for erroneous thinking and improper action in regard to depreciation in connection with valuations made for purposes of rate regulation. Confining his attention to the physical property element in the valuation, he argues that the property taken as evidence of the investment can and should be valued for that purpose as tho it were new, without allowing for age, wear and tear, and obsolescence, in the case of large and varied properties, except for depreciation allocated to a period in which depreciation accruals were legally charged to operating expenses. In this opinion Professor Young ranges himself with Mr. James E. Allison, public service expert, and till recently chief engineer and influential member of the St. Louis Public Service Commission, which alone has adopted the policy for which argument is made. As frankly he sets himself against the accepted opinion of the day.

Much in Professor Young's article is above criticism. To the notion of a "state of normal average depreciation" attention deserves to be called, and the figures cited easily emphasize the importance of the issue here raised. The summary of certain developments in the accounting regulations of the Interstate Commerce Commission is valuable, tho intentionally not comprehensive. The statement and illustrations regarding the

1 Depreciation and Rate Control, vol. xxviii, pp. 630–663, August, 1914.

And in

depreciation of particular assets are helpful. particular I should cordially assent to the first of his three summarized conclusions in the form in which it is stated. Furthermore, he would be bold who would undertake to defend public service commissions, or even the United States Supreme Court, against charges of looseness, inconsistency, and inaccuracy of statement, or to support all their rulings. Members of these bodies cannot be experts in all fields or infallible in any, and and their reasoning and conclusions frequently merit criticism.

Nevertheless, on the fundamental issue which Professor Young raises I am convinced that the current view is correct, and that the attack upon it deserves no support from economists.

The issue may be resolved into three separate questions, all relating to deductions, in valuations for purposes of rate control, for depreciation of physical plants operated by public service companies, during periods when such allowances for depreciation were not prescribed by law.

1. Is such deduction necessary in order correctly to state the present investment in the plant?

2. Is such deduction, retroactive in its effect, just to public service companies?

3. Is such deduction, involving (as it ordinarily does) the carrying of a permanent reserve for accrued depreciation, expedient?

The first of these is purely a scientific question, in the realm of economics and accounting. The second is an ethical question, involving the propriety of a sort of ex post facto legislation, but also, be it noted, the problem of equality of treatment of different companies. The third is purely a question of public policy, not wholly dependent upon the answers to the first two.

To each of these questions, tho he does not consider them in this precise form or order, Professor Young would give a negative answer. Let us consider them in turn.

We may begin by asking whether we can arrive at a closer approximation to the "present value" or "amount of the investment " by regarding or by disregarding age, wear and tear, and obsolescence ?

1

The editor of the Railway Age Gazette recently remarked: "William Mahl, of the Southern Pacific, expressed the feeling of a great many practical railroad executives when he argued that if a car or locomotive were kept in perfect repair it did not depreciate." This is not an uncommon notion among business men generally, tho it would be accepted by few accountants or economists. Professor Young would not make this particular statement, for he is at pains to describe the nature of depreciation of individual capital goods; nor would he say it of a plant in which one physical unit was of dominant importance; but he comes perilously near to saying it with respect to a property so varied that

no single wasting asset or group of assets is of dominant importance" and repairs, renewals, and replacements are normally fairly regular in amount. "There is no necessary correlation between the mere aging or even the physical wear and tear of capital goods and the diminution of the investment. The concrete facts in the case are few. When capital goods are installed their cost is a definite amount of investment; when they are retired from use the investment is diminished by the amount of their cost, minus salvage. If such capital goods are replaced promptly when retired, is not the amount of the investment, in every real sense, kept intact?" (pp. 650–651). In other words, the indi

1 Vol. Ivi, p. 727, March 27, 1914.

vidual capital goods indeed depreciate; the plant, the sum of them, under the conditions described, does not. The whole is not equal to the sum of its parts. Hence to deduct from the original cost or replacement cost an item for accrued depreciation on the items of the plant would involve an understatement of the "amount of the investment."

It is highly probable that Professor Young overestimates the strength of the tendency to regularity of replacements and the maintenance of a steady level of "productive efficiency "; but this is, after all, a question of fact rather than of principle. Granting that the facts are as he assumes them, is the " present value" or the "principal of the investment" independent of the depreciation of individual items in the plant?

To my mind, the reason why capital goods are wanted and valued at all is that they possess capacities for contributing certain services toward the completion of the productive process and its result in valuable finished products. Each bit of material, each machine, each tool, is wanted and valued because it embodies a certain store of productive power which can be brought to bear in the productive process. As each unit wears out, or ages, or becomes obsolete, this store of productive power is exhausted or leaks away. For the day, an old car or locomotive may be "as good as new"; with proper repair its daily or monthly serviceability or output may remain constant; but the diminution of its productive power goes steadily on. Moreover, it seems to me, the relative values of different capital goods are determined by the relative amounts of productive power which they contain; and for the same reason the relative values of a single machine or other capital good at different times are naturally determined by estimates of the productive

power therein embodied. In short, as the decline in productive power takes place the item depreciates in value. We cannot accurately ascertain the precise extent of the diminution of productive power, hence the figure for the value of a partly worn or partly aged capital good is more or less inexact. But of both decline and depreciation we may be certain.

And can the summing up of the multifarious units of a physical plant blind us to the fact of diminished productive power in an old plant as compared with the same plant new? Its daily capacity may be no less; with proper repairs and replacements that capacity may never decrease; with such "maintenance" the productive power of the plant will not decrease below a certain point; but unless the equipment has been increased and the capacity thereby enlarged, the store of productive power in the plant will inevitably decline as, from a state of newness, the state of normal average depreciation is approached. This is inevitable for the plant as a whole, as depreciation is inevitable for each individual item in it. It occurs irrespective of the beliefs, hopes, or wishes of investors or managers, regardless of accounting standards or the law, independent of actions or theories of public service commissions or the courts. One may be unable to measure the precise extent of the decline; one may shut his eyes to it entirely; one may show it on the books in one way or another or not at all; one may or may not need to alter his industrial or financial policy because of it: but the fact remains. The decline is the result of forces beyond the control of proprietors, courts, or commissions. The plant in a state of normal average depreciation has something like fifty or fifty-five per cent as large a store of productive power as a new plant of similar make-up and producing capacity.