depreciation fund. Or, the par value of capital stock or the stated surplus may be reduced, or the deficit figure increased, by the amount of the depreciation reserve, so that the "net proprietorship" figure will correspond to the actual amount of the investment. Business conditions, in the main, will determine which is the best procedure in each concrete case. Public service commissions may well be wary of laying down precise regulations as to the method to be adopted, provided the result be secured; but the mere requirement of recognizing the fact of past depreciation and taking it into account involves no burdensome or inexpedient control of financial policies of the companies concerned.

To conclude:

1. The requirement of an allowance for depreciation is necessary in order to state with an approach to accuracy the "present value" of or the present "amount of the investment" in a physical plant.

2. Such requirement, tho affecting companies which had deemed no such allowance necessary, involves no injustice to particular companies, while the absence of such requirement when making valuations for purposes of rate regulation would lead to unequal treatment of companies which had pursued different policies.

3. The presumption in favor of the expediency of such a requirement, raised by the foregoing facts and by the further circumstance that such "cost-keeping tends to promote more intelligent conduct of the enterprise, is not overthrown by the appearance of any consequent inexpedient restrictions on financial policies.

Or, restated in a form comparable with that of Professor Young, these conclusions would be:

1. If depreciation charges have not been required by public authority, it cannot be assumed that the proprietors of a large public service undertaking should have

accumulated a reserve for accrued depreciation or a depreciation fund of the same amount.

2. The absence of such a reserve means, however, that the value of the physical plant is by so much overstated, and indicates that, unless an equivalent amount of earnings has been applied to extensions of plant without "charging to capital" or has been invested in other property or has been expended in building up immaterial assets which do not appear on the balance sheet, part of the principal of the investment has, whether intentionally or otherwise, been returned to the proprietors.

3. It is proper, just, and expedient that in valuation for purposes of rate control account should be taken of depreciation of the physical plant, regardless of the need or lack of need for a depreciation fund, and regardless of the actual or hypothetical expectations of the proprietors as to the necessity of reckoning with depreciation by means of the depreciation reserve or otherwise.

JOSEPH S. Davis.

HARVARD UNIVERSITY.

A REPLY

I had not expected that my conclusions on the relation of depreciation and rate control, challenging generally received opinion as they do, would meet with easy acceptance. I am grateful to Mr. Davis for having cogently formulated some of the objections - the more weighty ones, I imagine that may seem to count against my thesis. The right solution of the problem is a matter of great practical consequence, and discussion which, like Mr. Davis's, helps to define and narrow the issues, contributes toward that end.

We are agreed upon some points. It is admitted that it is not necessary for undertakings with large and varied properties to accumulate a "reserve for accrued depreciation" in order to provide for replacements. It is further admitted that in the valuation of the properties of such companies for the purpose of rate control the usual deduction for depreciation cannot be justified by appealing to the alleged necessity of providing in advance for renewals. But it is upon precisely that fallacious ground, and in most cases upon that ground only, that commissions and courts have based their rulings that depreciation must be deducted in such valuations. Are these findings to be approved in spite of their admittedly faulty premises? At this point Mr. Davis and myself part company. I see no principles on which the deduction for depreciation can be definitely justified in the case of the valuation of the properties of a company which has not accumulated a depreciation reserve. Mr. Davis thinks that there are such principles, even tho overlooked by commissions and courts, and attempts to formulate them.

But before proceeding to the discussion of the real issue, I must first enter a protest against Mr. Davis's interpretation of part of my argument. In view of the fact (on which we agree) that when annual replacement needs are fairly uniform there is no need to provide a fund for them in advance, I spoke of the reserve for accrued depreciation as "useless for replacement purposes." Mr. Davis fears that I have confused the depreciation reserve with " a thing essentially different, namely a segregated fund of particular assets, cash, securities, or what not, which may be drawn upon to meet ordinary or extraordinary repairs, renewals, and replacements." Now, I have no fault to find with the exposition of elementary accounting practice which Mr. Davis

introduces at this point. But I cannot understand how Mr. Davis has convinced himself that I fell into the error in question. A reserve of the kind under discussion is built up by credits of depreciation accruals and depleted by debits for replacements. Itself a liability account, its effect is to hold a corresponding amount of (unspecified) assets in the business and to prevent their distribution except at the expense of an equivalent diminution in stated liabilities. Only as replacements are made are these assets released. And so far as the reserve is permanent such assets cannot be released in exchange for replacements. To say that the reserve "cannot be used for replacement purposes "avoids much circumlocution and should mislead no one. use a depreciation reserve for replacements is just as commonplace a feat as to "pay dividends out of profits.' One assertion which Mr. Davis makes in this connection is, I think, a little too strongly put. He says: "The depreciation reserve proper has nothing whatever to do with ability to make expenditures for replacements or renewals, regular or irregular, except in so far as it may insure more comprehensive knowledge of the plant and thereby facilitate intelligent prevision of future needs for such purposes."

To

Now, of course, the existence of a depreciation reserve does not insure the existence of a body of "idle cash " or of easily convertible assets held against possible replacement needs. But it does make it certain that all needed replacements up to the amount of the reserve may be made without either cutting into surplus or increasing the deficit for the year. In practice the reserve for the depreciation of large and varied properties becomes much larger than can be " used " in this way for replacements, and to this extent is " unnecessary" for replacement purposes.

I must repeat a statement which Mr. Davis quotes from my paper: "Altho no investment of a separate depreciation fund is required [by the Interstate Commerce Commission], yet the writing down of the capital assets by the amount of the 'accrued depreciation means in the long run either that other assets have to be larger in amount than they otherwise would have been or that liabilities have to be smaller. Usually the growth of the reserve for accrued depreciation means in practice that additional permanent investments are being made out of earnings." This statement is, I think, both accurate and perfectly general. It covers the three methods of handling the matter which Mr. Davis particularizes.

Mr. Davis probes much deeper, it seems to me, when he questions my use of the term " productive efficiency." My argument made some use of the assumption that a properly maintained plant in a state of normal depreciation would yet be in a condition of substantially unimpaired productive efficiency. Mr. Davis formulates his objection to this in two ways. In the first place, he suggests, the value of a plant depends upon its store of productive efficiency, and this involves the aggregate expectation of life of the various parts of the plant. This store of productive efficiency is less for a normally depreciated plant than for a new one. In the second place, productive efficiency, adequately interpreted, "" must have reference to the relation between the output and the total cost of producing it." When renewals have reached their normal level their annual cost will be greater than in a new plant. A plant requiring larger annual maintenance expenditures per unit of product than a new plant would (in the immediate future) cannot properly be said to be in a state of unimpaired productive efficiency.