In connection with the depreciation rate, attention is called to the necessity of ascertaining and applying standards that have been developed in practice under expert observation. The mere guess of the manager or board of directors as to how long certain property will last, is neither necessarily correct nor likely to be so. In practically every industry, qualified engineers have found from experience the depreciation which applies under given conditions to each class of equip ment. Unaccountable and incalculable variations in the quality, usage or upkeep make it impossible to apply an absolutely accurate rate in any case; but it can be made approximately correct so far as physical deterioration goes.
To apply a rate of depreciation, the present physi cal condition of the asset should be known, and a standard of condition maintained as closely as pos sible. The leading corporations keep a careful rec ord of each piece of equipment, and the repair gangs are expected to maintain it as near as possible to a set standard. The reserve for physical depreciation of the corporate assets, as a whole, is then determined by adding together the annual amount of deprecia tion upon each unit. The cost department of nearly every large corporation has an inventory of its equip ment, with the rate and amount of annual deprecia tion set opposite each item, and the total constitutes the depreciation reserve for the year against ordinary physical or market impairment of values.
Contingent and extraordinary depreciation cannot be calculated in the same manner. Several methods are employed of treating depreciation resulting from obsolescence, changing legal and business conditions, or accidental destruction: 1. Nothing is provided against them in the belief or expectation that appreciation of portions of the property will offset depreciation from these three causes 2. Annual betterments to a certain extent are made out of earnings and charged to operating expense 3. A certain arbitrary amount to cover these losses is added to the annual depreciation reserve.
8. Appreciation as an off set to few fixed assets, except land, appreciate in value. Buildings, machinery and other equipment rarely in crease, altho occasional causes, such as war, may put a temporary premium upon certain kinds. A very rapid and severe increase in prices, such as was wit nessed during the European war, may, for the time being, apparently increase the value of fixed capital more rapidly than it depreciated, because of tem porarily stimulated production and earnings. A de
cline in prices works in just the opposite direction, and, unless the asset is one which is to be sold during the period of high prices, in the regular course of business, the appreciation cannot be counted to offset depreciation.
Unless the appreciation can be traced directly into the income account, thru decreasing cost of produc tion, or positively increased income from sales, it is scarcely available for any actual replacements. The appreciation of land values may not be realized until the business is wound up or its 'plant relocated. Meanwhile no benefit is derived from the apprecia tion, and perhaps increased taxes are paid. The im proved value, it is true, does enhance the company's capital and increases its borrowing power, but if con sidered as an offset to depreciation reserves, this policy is likely to necessitate the issue of new securi ties to obtain capital for replacements later.
9. Depreciation reserve.—A depreciation reserve consists of a certain portion of the annual earnings, or accumulated surplus, which is kept in the business or available to it, and which is accounted for on the books as an amount retained specifically for the pur pose of meeting losses and replacements necessitated by depreciation of assets. Care should be taken to distinguish between reserve, surplus and sinking funds. Sinking funds are always invested outside the business, to retire, or in contemplation of retiring, a part of its debt. Reserves and surplus, on the other hand, are retained in the business. All three have as their essential object the maintenance of the value of the capital stock; the reserve by maintaining the pro ductive value of assets; the surplus by guaranteeing regular dividends; the sinking fund by retiring part of the company's funded indebtedness.
Neither upon the books nor in actual practice, is there any essential difference between reserve and sur plus, except that actual surplus is a proper source of dividends, while reserves are not. The slightness of this distinction accounts for the fact that many corn panies which possess a reasonable surplus do not vide reserves, but depend upon the surplus to take care both of depreciation and dividend requirements.