CHAPTER XXIX DEDUCTIONS FOR DEPRECIATION Depreciation is a decline in the value of property such as may reasonably be expected to occur as a result of wear and tear and gradual obsolescence. It is due to the possession and use of assets, and therefore is a part of the cost of operation. P. D. Leake defines it as "expired outlay upon productive plant." The phrase "accrued renewals" sometimes used to describe depreciation is illuminating. It is to be noted that depreciation is usually treated as a comprehensive term to include all declines of the nature described above. LAW. Section 214 (a-8) [Individuals]; Section 234 (a-7) [Corporations]. That in computing net income there shall be allowed as deductions: 1 A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence; Section 215. That in computing net income no deduction shall in any case be allowed in respect of [Individuals] (b) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; (c) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made;2 The limitation on deductions by corporations (section 235) is the same as for individuals. '[Former Procedure] 1913 law. Individuals. "A reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in the business." Section II B, Sixth. Corporations. "A reasonable allowance for depreciation by use, wear and tear of property if any." Section II G (b), 1916 law. Individuals. The words "or trade" were added. Corporations. The words "and charged off" were inserted. 1917 law. Corporations. The words "actually sustained" were added. Section 12 (a), Second. Sections (b) and (c) are substantially the same as in the 1913, 1916 and 1917 laws. In the regulations of the Treasury depreciation "applies to that which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence due to the normal progress of the art or to becoming inadequate to the growing needs of the business." What may be termed ordinary obsolescence will be discussed in this chapter. Separate chapters in this book are devoted to extraordinary obsolescence and to depletion. It will be clear from the context whether depreciation is used in the inclusive or in the restricted sense. Public accountants for many years have urged upon their clients the importance of ample allowances for depreciation, but the campaign has not been an easy one. The tendency is towards insufficient rather than excessive depreciation reserves. Edward N. Hurley, former chairman of the Federal Trade Commission, stated that "out of the 60,000 corporations that report an annual income of $5,000 or over, half do not charge off a single penny for depreciation." Depreciation is often treated as though no accurate estimate of the life of assets were possible, with the result that in some cases excessive reserves are created and in other cases there are no reserves at all. Perhaps the controlling reason for this variation of practice is a desire to utilize this as an elastic factor to bring about a desired effect on the balance sheet and the profit and loss statement. In some cases it is also felt that excessive book valuations may favorably affect the insurance adjustment in case of fire, but this fallacy is gradually losing ground. The recent improvement in methods of allowing for depreciation can be traced in large part to the installation of cost systems, which have brought about an increasing recognition of this factor as a necessary cost of production. Another powerful influence in the direction of accurate and adequate reserves has been the enactment of federal and state Article 159 of Regulations 33, 1918, differentiated depreciation from "depletion, obsolescence and other losses." 'See Chapter XXX, "Deductions for Obsolescence," and Chapter XXXI, "Deductions for Depletion." income and other tax laws calling for returns of net profits. Altogether there has recently been a general awakening to the fact that depreciation is a vital issue in correct accounting. There are still wide differences of opinion as to the amount of the allowance which should be made from time to time. Many company officers prefer even yet to regard depreciation charges as flexible. They adjust them to meet the conditions of different years, so that in times of large profits the allowance is large and during bad years small. This, of course, is entirely opposed to sound accounting principles. If the business man passes over one year without making any allowance for depreciation, the result is a misrepresentation of conditions at the end of that year. It is unjust and incorrect in every way to expect a good year to bear the burden of depreciation which has occurred in one or more bad years. Net profit means only one thing in the vocabulary of the professional auditor-a meaning which should be universally recognized—and that is the excess of income over operating costs, expenses and losses. It cannot be determined by taking into account all the income and a part only of the charges against income. Full provision for depreciation must be included among the costs of operation, or the result may not be accepted as representing net profit. Statements, sometimes encountered in published reports, to the effect that a corporation has realized net profits amounting to a certain sum and that out of these profits an allowance for depreciation has been made are both misleading and illogical. It is an unfortunate fact that the efforts of accountants to secure the establishment of proper depreciation reserves have in some respects been retarded and hampered by the attitude of certain inspectors in the administration of the income tax law. Part of the difficulty has been due to a mistaken general policy on the part of the government in favor of strict limitations on depreciation. In the first place, reserves for this purpose, if found in the future to be too large, will be ultimately taxable for any excess, and, in any case, the government cannot afford in the long run to ignore sound economic principles in determining net income. Perhaps the greatest share of the trouble is due to the action of incompetent inspectors who sometimes arbitrarily insist upon a reduction of reserves to insufficient amounts. Fortunately their action is rarely sustained by the officers of the Treasury, whose recent attitude in the matter of depreciation and depletion has been in accord with good accounting practice. Applicability of rates of depreciation used in prior years.— Taxpayers who use substantial rates of depreciation are sometimes embarrassed by examiners who apply the rates used in 1917 and 1918 to their plant accounts for many years prior. It may turn out that a literal application of the rates will practically wipe out the plant account at January 1, 1917, and thus greatly reduce the allowable invested capital for excess and war profits purposes. The method, of course, is inaccurate and falls of its own weight. In most cases it is possible to prove that on January 1, 1917, the actual value of the plant, without taking appreciation into consideration, greatly exceeded the theoretical valuation. Such result does not in itself prove that because the rates are incorrect as applied to prior years they are also incorrect as applied to 1917 and 1918. The rates are incorrect as applied to prior years because during those years the renewals, repairs, maintenance and capital outlays charged to operations greatly reduced the reserve necessary to reflect accurately the net going value of the plant on the books of account. One concern charging high depreciation rates for 20 years prior to 1917 might show the same net plant values at the end. of the period as a concern which charged off no depreciation, as such, during the entire period. Prior to 1917 it made little difference to many concerns what rates of depreciation were charged. Furthermore, during 1917 and 1918 there were good rea sons for greatly increasing depreciation rates over those formerly used. The British War Ministry cannot be charged with holding a brief for American manufacturers; therefore the rates of depreciation suggested in official memoranda of the War Ministry are of great interest as having direct bearing on conditions in the United States. When normal rates of depreciation on machinery were 72 per cent per annum it was suggested that there be allowed the following additions: Addition for unskilled labor up to 50%... Total additions Normal rate Total 334% 114 15% 72 222% 25% Maximum allowance Engineers of the War Department of the United States reported that the British additional rates were too liberal and recommended that the maximum to be used in the foregoing example be fixed at 15 per cent. Taxpayers whose accounts are being examined should give careful attention to the actual conditions during 1917 and 1918 and when special depreciation was warranted by existing conditions, as compared with previous practice, they should insist on proper allowances. Conditions Precedent to Allowance for Depreciation The general provision in the regulations which sets forth the conditions which must be met before a deduction for depreciation is allowed reads as follows: REGULATION. A reasonable allowance for the exhaustion, wear and tear and obsolescence of property used in the trade or business may be deducted from gross income. For convenience such an allowance will usually be referred to as covering depreciation, cluding from the term any idea of a mere reduction in market value ex |