CHAPTER 1

DEFINITION OF DEPRECIATION

In many areas of human action where practice dominates,

rigorous theoretical support on such practice is rarely found.

Depreciation is treated in the accounting practice in this like

fashion (1). A number of methods have been prescribed to calculate

depreciation, but a little attempt has been made by the accountants

to formulate a scientific and cohesive theory of depreciation.

If we assemble the scattered comments on the subject given so far

in the accounting literature, depreciation can be defined as:

(a) reduction in the value of fixed assets due to wear and tear,

obsolescence and lapse of time, (2)

(b) a measure of the wearing out, consumption or other loss of

value of fixed assets, whether arise from use, effluxion of

time or obsolescence through technology or market changes, (3)

(c) a process of allocation of cost of fixed assets, (4)

(1) Mukherjee, K. and Sengupta, S., Depreciation: Theory and its

Uses, Studies in Accounting Theory Ed. by Roy G.D., and
Mukherjee, K. , World Press (1981) pp.249.

(2) Northoott, L.T., and Forsyth, S.SPractical Book-keeping

and Accountancy, 1949, pp.89.

(3) S.S.A.P. 12, issued December 1977.

(4) IAS 4 Depreciation Accounting.

(d) an expiration of capital outlay, (5)

(e) either loss in the value of individual units of capital

assets used in the operation of a business, or the reduction

or "write-down" in capital cost of such assets (6).

Economists, in general, are used to identify depreciation

as 'diminuation of value' or ’deterioration in the value of the

equiponent' (7). Keynes, in his General Theory, introduced the

subject in terms of user cost (8), In his opinion user cost of

an entrepreneur is

(&' - B') - (& - ) which measures the sacrifice of value

ct
involved in production. Here G' represents the value that all

equipments, both old and new, (acquired within the period)

including inventories, would have attained at the end of the

period, because of the benefit derived from maintenance charges

B', had they not been used in production. G, however, represents,

what the said value would come down to because of the use of

equipments in production. .... As stands for the part of

user-cost due to consumption of materials purchased from other

(5) Leake, P.D., Depreciation and Wasting Assets and their

Treatment in Computing Annual Profit and Loss
Sir Isaac Pitman & Sons. Ltd., London, pp.5. D71C Edili*?*.

(6) Bauer, Jaun, Depreciation, Encyclopaedia of ■the Social Sciences,

Vol.5, Macmillan & Co., 1937, PP.98.
(7) Hoy, G.D., Anatomy of Depreciation, PP.33, World Press,
Calcutta, 1977.
(8) Keynes, J.M., The General Theory of Employment, Interest,
and Money, Macmillan & Co. Ltd., London, 1964, PP.53.
producers within the period, the other part i(«’ - B') - & may

he considered to represent a measure of aggregate depreciation

suffered by all material equipments of a firm as a whole within

that period." (9). It is interesting to note that Keynes, in his

idea of depreciation, made a difference between user cost and

supplementary cost. In his opinion, the later represents

depreciation for factors other than use. "There lies the difference

with the accounting view which not only excludes inventories from

the purview of depreciation, but considers it a single-whole

without being split-up into ’user' and 'supplementary' costs."(10),

So far as the valuation of asset is concerned, Economists,

in most cases, resort to DCF technique which owes its origin, to

the work of the economist Irving Fisher (11) and others who have

refined his ideas (12, 13). Asset at any point of- time is calculated

under this approach by the summation of the discounted values of

all net cash inflows which are expected to be earned by it.

Discounting is the process by which cash flows of different time

periods may be equated to a single sum of money which would have

(9) Ibid (7).

(10) Ibid (7) PP.41 .

(11) Fisher, Irving, Income and Capital, Readings in the Concept

and Measurement of Income, Edited by, Parker, R. H., and
Harcourt, G-.C., Cambridge University Press, London, pp.33-53.

(12) Ibid (6) pp.135-137.

(13) Edwards, E.O., and Bell P.V/., The Theory and Measurement of
Business Income, Berkeley, University of California Press,
1961.
 1.4

equal value if received immediately. The process recognises that

Re.1 received in one year's time is less valuable than Re.1

received to-day, and that individuals or business entities would

normally require some compensation, i.e., in the form of interest

receipt's, for delay in consumption. The present value approach

has been criticised on a number of grounds including subjectivity

in the choice of discount rate etc. and the unoertainity attached

to the expected cash flows (14). However, subjectivity and

unoertainity are present to a greater or lesser extent in all

valuation bases. Again, there are many concepts of value. If an

non-accountant is asked to provide a definition of value, he might

attempt to relate it to such concepts as 'worth*, 'utility*, or

'desirability'. "Regrettably, such definition do not coincide

with those implied by the historical cost accounting treatment of

depreciation" (15). The purpose of the accountant's depreciation

charge is one of cost allocation, depreciation is the part of the

original cost of an asset whioh has been or is being written off

to the income statement in rational manner and the amount shown in

the balance sheet is that part of the original c.ost of an asset

that has not been charged to revenues. In neither case does the

asset amount shown in the balance sheet necessarily bear any

resemblance to such notions of 'current value' as current replacement

cost or selling price except by accident. (16).

(14) Ibid (7) pp.38-39.

(15) Arnold, J. et al, Financial Accounting, Printice Hall
International (U.K.) Ltd., 1985» pp.148-149.
(16) Ibid (15).
 In Engineering, the concept of depreciation is treated as

a physical function of time and considers it equivalent to

physical deterioration due to wear and tear or loss of working

capacity per unit of time. (17). As a result, identifying

depreciation as a physical function of time alone engineering

concept of depreciation centres round only to the physical aspect

of an asset. But the accounting depreciation identifies Both

physical and economic aspect of depreciation and stresses more on

economic effect of depreciation on an entity than on the causes

of depreciation. Nevertheless, there lies areas where the

■o

engineering techniques can be successfully applied retaining the

basic character of the accounting depreciation. In fact, our

studies have tried to explore these areas.

In view of the above observations, we may refer here praise-

i

worthy efforts of Prof.Roy in arriving at a well-comprehensive

definition of depreciation. In his words "Depreciation of durable

fixed assets which as a physical or economic phenomenon' or both,

is recognised as the consumption or expiration of the asset

itself or its value, cost or life, or as that of the capital

outlay made thereon, consists of as an accounting device practiced

over an estimated number of accounting periods, a periodical

charge to revenue made on any reasonable basis that results in,

on the one hand, an imputed allocation of cost or expense, and

(17) Finney- and Miller, Principles of Accounting, Intermediate,

Printice Hall, India, I960, pp.355.
on the other, part-recovery of capital outlay, equal to a fund

arriving in general thereunder which is allowed to accumulate

against financing a possible replacement of the asset whose

historical cost or recorded value is, at the same time, reduced

in the'process by the amount of the said charge or is shown

diminished by a provision created out of the same." (18).

The list can be made lengthier than above, but the vagueness

of the definition of subject still persists to-day. Of course,

searches are going on to find out a widely acceptable definition

of depreciation theory, old ideas are yielding place to new.

Two of these ideas developed by Hotelling and Wright are briefly

discussed here.

Hotelling (19) introduced his 'general mathematical theory

of depreciation* with the following assumptions.

(1) that owner of a machine or property wishes to maximise

the present value of the output minus the operating costs of

the machine or property,

(2) machine is always operated at full capacity,

(3) the property involved in all analysis is referred to

as machine purely for convenience of language,

(4) continuous function, instantaneously compounded interest

and integration is used in solutions of equations should be

adopted for the need of the theory developed.

(18) Ibid (7) . pp.195.

(19) Hotelling, Harold, General Mathematical Theory of Depreciation,

Headings in the Concept of Measurement of Income, Ed. by
Parker, R.H., and Harcourt, G., Cambridge University Press,
1969, pp.261-75.
 (5) risk of obsolescence is to be included in the operating

expenses treating it similar to insurance premium.

With the above assumptions he introduced the fundamental

formula of depreciation in the following equation

r(x) = *Y(r) - o(t)

where

0 ('£)= Operating cost.

Y{X)= Units of output per year at time 'X

X = theoretical selling price of a unit of output

Rtr> Annual rental value at time “X

The value of machine is thus conceived to be the sum of the

anticipated rentals which it will yield, each multiplied by a

discount factor (varying with time in most cases) to allow for

interest plus the discounted scrap or salvage value.

"If S(n) is a function giving the scrap or salvage value

at the time n at whi'ch the machine is to be discarded, th.e

value at time t is given by the following fundamental formula:

V(ti - j"UY(y - 0(t)J e*p J r S {*) l*}

*f S(-n) exp J * S{v) ^ (1)
*X and ^ are the variables of integration representing time.

When § (t) is defined as rate of increase of an invested

sum *5 divided by *5 then Hi) = i is

■i it-

By integration
6 =. 5o exp ^ j ,
 Where 3 the value of invested amount when t = o and ^ is

a variable of integration. Hence 50 = i>

exp|-J
o
The value at time t of a payment to be made at time X iB the

amount of the payment multiplied by ^ — J $ (*0 d-2^ ^

- a
If v is constant this discount factor equals to vi ^- t

When interest rate is constant the equation (l) is reduced

to
V(^ = ("[aw - .r-t- + SCn)J>T,‘t
w
r A

If c is the cost of a new machine, we have t ** o,

hence
V(o) a j £* Y('t) - 0(^)j exp^-J £(>$ ci.2?jc(r
0 0
n ..
+* S Cn) exp ^ ^ <S (a2) J

With these expressions, Hotelling extended his study with

the alternative assumption that owner seeks to increase his

profits by slowing down production.

He formulated methods to find the value V(t) when the useful

life n of the machine is known when x is known or vice versa

or when both are unknown. He freely used the tool of integral

equation to resolve the problem associated with the operating

expenses when it is proportional to value. With his equations

he tested the most commonly used depreciation methods to justify

his 'general mathematical theory of depreciation.1

 "The essential ingredients of a general theory of depreciation

can he found in the pioneering contributions of Hotelling and

Canning. Canning developed the concept of opportunity value,

but apparently failed to see that in a dynamic economy this value

must be allowed to vary over time. Hotelling understood the need

for expressing his 'theoretical selling price' as a function of

time, but lacked the opportunity value concept necessary to defend

his theory against the objections later put forward by Preinreich,

when these complementary concepts are brought together, a general

theory of depreciation begins to emerge." (20). This general

theory was given by Wright in the equation

D(t) = RQ(t)-B(t)-iV(t-1 )

where D is the depreciation charge, R is the replacement cost of

the service, Q is the no. of units of service produced, E is the

operating expense, i is the rate of interest, V is the value

of the machine and t is the time period.

Canning's theory, on which the above equation is based, is

V .-V = D
a-1 a a
where 'a' is the annual charge for depreciation. (21)

Wright discarded the accounting approach to depreciation

wherein it has been described as 'a process of allocation.' He

(20)pHight, P.K., Towards a General Theory of Depreciation,

Readings in the Concept of Measurement of Income Ed. by
Parker, R.H., and Harcourt, G.C., Cambridge University
Press, 1969, pp.286.
(21) Canning J.B. Economics of Accountancy, Ronald Press Company,
New York, 1929, pp.300-301.
 1 .10

adopted the economic approach which represents depreciation as a

process of valuation. He pointed out three main problems of

valuation of an asset. They are (1) the problem of forecasting

the future services of assets, (2) the problem of valuing those

future services (3) the problem of determining appropriate rate

(or rates) of discount. In his opinion, failure to solve the

second problem has prevented the construction of a satisfactory

theory of depreciation. Wright reduced the problem of valuing

services of an asset to the problem of determining the alternatives

to ownership of that asset, assessment of the costs or losses

associated with those alternatives, and selecting the least of

those costs or losses to represent the value of the services.

Wright divided alternative to ownership of an existing

assets into two groups: those which involve cessation of production

of the services^providing by the existing assets^and those which

involve producing those services in some other way. He defined

cost of the cheapest alternative in the first group as 'utility'

and that in the second group as 'replacement cost.' To measure

the value of an asset he coined the phrase 'opportunity value'

which is measured by the least costly of the alternative avoided

through owning the services. Thus the opportunity value of the

services of an asset at any point of time will then be lower of

utility or replacement cost. 'Thus, if the utility of the service

is below its replacement cost, the value of the service to its

owner will equal its utility; if the utility exceeds the replacement

cost of the service its value to the owner will equal its replacement
 1.11

cost.' Wright assumed that the value of the services of newly

acquired machine is equal to their replacement cost. In his opinion,

the utility of the services of the asset, at this stage, is

usually so great to the firm that it would pay to continue to

provide them even if the existing machine were suddenly destroyed.

He also assumed that for every service now being provided, there

will come a time when its utility falls below replacement cost.

Thus supply of the services of the asset will not continue to

be required for ever.

Wright considered a case of a service whose utility exceeds

it replacement cost, so that its value is cost-determined. He

assumed stable prices and static technology. On these simplest

assumptions, "the most economical method of providing the service,

should an existing machine be suddenly destroyed, would be by

the purchase and operation of identical machine. The assumptions of

stability also imply that the replacement cost of the service will

be constant from period." He, therefore, defined replacement

cost as the constant average unit cost of obtaining the service

from a hypothetical substitute for the existing machine. "This

average unit cost will be a minimum if the substitute machine is

operated for the optimum number of years, the minimum average

cost may therefore be determined by solving for 'R' in the equation

r
C

where C is the capital cost of the substitute machine,

Q(n) is the number of units of service produced by the machine

during the nth period of its life,
 1.12

E(n) is operating expenses incurred during that period, (for

greater ease of discounting it has been assumed that all services

are received, and all operating expenses incurred, on the last

day of the period).

i is the rate of interest, expressed as a fraction per period.

S(n) is the salvage value of the machine at the end of the

nth period, and

T is the economic life of the machine, i.e., that life which

leads to the minimum value of the average unit cost R." On

assumption of stable prices and static technology, the value of

C and the functions Q(n), E(n) and S(n), will be exactly the same

for the hypothetical substitute machine as for existing machine.

The value of the existing machine at the Tth period of its life

will be
V(t) = 2. Z“HQ(n)-E(n)_7(l+i)t_n + sCTHl+i)*-1
n=t+1

•and depreciation during the Tth period will be

l)(t) = V(t-1 )-V(t)

l_ introducing iV (t-1 )mmJ
= V(t-1) + iV(t-1 )-iV(t-1 )-V(t)
= (1+i) V(t-1)-iV(t-1 )-V(t)
= (1 + i) | il ZRQ(n)-E(n)_7(l+i)t“n‘"1 + S(T) (l+i)*-1-1 ]

n=t -V(t)-iV(t-1)

= 71ZaQ(n)-E(n)Jr(l + i)t-n +s(T)(l + i)t“'®

n=t -V(t)-iV(t-1)

T
= RQ(t)-E(t) + 21 Z^Q(»)-S(n) J^Cl+i)11"11 + S(T)(l+i)t_T
n=t+1 -V(t)-iV(t-1 )
= RQ(t)-E(t)+V(t)-Y(t)-iV(t-1)
= RQ(t)-E(t)-iV(t-1 )
 1 .13

Both Hotelling and Wright streamlined their idea of depreciation

on, the basis of the fact that depreciation of an asset arises not

out of wear and tear due to its use but from obsolescence. Shis

"approach needs to be seriously considered, particularly in view

of the -slipshodness with which the problem of obsolescence gets

treated in accounting and economics. It is often gratritously

taken for granted that obsolenscence arises only from new

inventions and innovation . . . But "most machine obsolenscence

is produced not by new invention, but by the changing patterns of

demand for the final goods, as affecting the value of the final

products which, as a fact, has been pointed, as being the greatest

lacunae of the Hotelling-Knight solution. Such changes may perhaps

be anticipated and to certain extent moulded: but by no means

accepted as a mechanical function of time, however, complicated."(22).

She foregoing discussion reveals the fact that fixed assets

depreciate in value for variety of reasons. They are subject to

"wear and tear" from actual operation. In addition, deterioration

in physical condition might result from vibration, friction,

strain, weathering or other things associated with the utilisation

of assets. It might be the result of mere lapse of time or might

be due to some rule of law or contractual agreement where the

period of ownership is made limited by them. But quite generally

fixed assets depreciate, when an asset is no longer required by

(22) Mukherjee, K. and Sengupta, S., Depreciation and its Uses,

Studies in Accounting Theory Ed. by Mukherjee, K. and
Roy, G.D., World Press, Calcutta, 1981, pp.259-60.
 1 .H

an enterprise for its original purpose due to availability of

equipment of an improved type or change in the productive

objectives of the firm. In some special cases depreciation arises

as a result of extraction of resources from mineral deposits,

oil wells and forests. In some cases, amortisation of the value

of such assets as leases and patent rights, which depreciate

solely as a result of the passage of time.

The aim of our study is not to present depreciation theory

as a boxing match in which each school of thought's theoretical

punches are chronicled. So we have tried to distill the essential

ideas from the theories on this subject in order to synthesise

and show how these theories contribute to our total understanding

of the subject in hand. Thus the above lines, should not in any

way, be understood to be an academic game of controversy

manufacturing, i.e., to see theoretical differences where none

exist.