SIDNEY DAVIDSON is Arthur Young Professor of Ac-counting in the University of Chicago’s GraduateSchool of Business and Director of the School’sInstitute of Professional Accountancy.

The Institute is in large part a product of Mr.Davidson’s work since he came to the Universityof Chicago from Johns Hopkins University in 1958.He was instrumental in the establishment of aworkshop in accounting research and inauguratedspecial financial aid for accounting students--twohighlights in the program to strengthen and ex-pand the activities of the Graduate School of Busi-ness in the field of accounting which culminated inthe formation of the Institute.

M r . Davidson has been a Visiting Professor of Ac-counting and Economics at the Universities of

Michigan, California, and Hawaii, at Stanford, andat the London School of Economics, in addition tobeing on the Johns Hopkins faculty for nine years.He is active in the American Institute of CPA’sand the Illinois Society of CPA’s and is a memberand former director of research of the AmericanAccounting Association. His published works in-clude Fundamentals of Accounting (with PerryMason and James S. Schindler) and Studies inAccounting Theory (with William T. Baxter).

“The Meaning of Depreciation” is a speech givenby Mr. Davidson at a dinner meeting of the Grad-uate School of Business Associates Program onMonday, April 30, 1962, at the Chicago Club. TheAssociates are representatives of companies whichhave undertaken to contribute to the support ofthe School on a regular basis.

Second Printing

N o v e m b e r 1964

The Meaning

o f

Depreciation

The topic of depreciation is one of the mostdisputed in all the relationships between ac-counting and business. And, of course, opti-mum practices and policies with regard todepreciation are still far from settled.

More than a quarter-century ago, HenryRand Hatfield, the second Dean of the Busi-ness School, wrote a very entertaining essay onthe subject, “What They Say about Deprecia-tion,” in which he pointed out some thirty-sixdifferent approaches or procedures to be usedin connection with the depreciation question.The quarter-century which has passed sincethat time has resulted not in consolidation ofideas but rather in a multiplication of ap-proaches, so that this whole question of whatdepreciation is, what it means, what should bedone with regard to it is one that is subject toa good bit of controversy.

One of the things that has certainly helpedto heighten the controversy in this area is theimportant place that depreciation plays inincome-tax calculations, especially when in-come taxes reach a 52 per cent rate.

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As far as the general nature of depreciationis concerned, there can really be no question.Depreciation is-and must be recognized asbeing-a cost of doing business, one that no-body can deny. The cost of a boiler is as mucha cost of doing business as the cost of the coal.It is true that plant expenditures may be moresporadic; nevertheless, these expenditures haveto be made. We all know that these facilitiesare used up in the carrying-on of the firm’sactivities. Therefore, as you can readily see,depreciation is a cost of doing business thatnobody can deny.

However, depreciation is a joint cost parexcellence. It is joint with respect to the sev-eral time periods during which a plant assetis used. It is joint with respect to the productsthat are turned out utilizing any piece ofequipment. It is joint with respect to the in-dividual units of production that are turnedout during any given time period. Economictheory suggests to us that joint costs cannot beallocated satisfactorily. Yet in a variety of cir-cumstances we are faced with the problem ofallocating these joint costs-costs which arejoint to an extent unmatched by almost anyother kind of cost.

The problem is complicated by the fact thatthe period of usefulness of most plant assets-the period over which this allocation is made-is usually relatively long. Changes in theeconomic significance of the units that we useto measure the expenditures that we havemade can come about fairly readily and, infact, frequently do.

The depreciation problem, in essence, boilsdown to three questions.

The first is: What kind of base should weuse in measuring depreciation? Should it berelated to the historic dollars that have beenexpended, or should it approximate somemeasure of the current cost of assets that havebeen utilized?

Second, over how long a time period should

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we attempt to allocate these costs? What is theservice life of the asset?

Third, what pattern of charge-off over thisservice life should we use?

With this background for the problem andthe uncertainty about depreciation, what doesdepreciation mean to the business firm and tothe economy as a whole?

We can say that to the individual firm de-preciation means a tax deduction, a factor inthe preparation of external reports, and aningredient in internal analysis.

To the economy as a whole, depreciation isa factor in determining the base for incometax. The procedure with regard to deprecia-tion in the legally defined notions of taxableincome has had considerable effect upon theequity of the income-tax law and upon therate and structure of economic growth withinthe economy.

Let us start with what depreciation meansto the business firm. Here let us turn to onearea where, I think, we can speak with a rel-ative degree of confidence, with relative assur-ance. This, of course, is the area of depreciationas a tax deduction for the business firm.

Within this area it seems clear to me thatthe goal of the firm should be to maximize thepresent value of the reductions in tax payments from claiming depreciation. In a flat-rate tax situation this is the same as saying wewant to maximize the present value of depre-ciation deductions. Of course, we can alwaysdeduct the cost of the asset over its life, butthe earlier deductions are worth more in thiscash-hungry world than the later ones. There-fore, our goal should be to maximize the pres-ent value of this stream of depreciation de-ductions and with this to minimize the presentvalue of the stream of tax out-payments.

Congress has presented business firms withseveral permissible alternatives to follow indetermining the amount of depreciation to becharged off each year. The pattern of depre-ciation charges is to at least some degree with-

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in the control of the business firm. It seemsclear that the firm should choose that alter-native which meets the general goal that wehave set forth-to pay the least amount of taxas late as possible.

We can put this more strongly by sayingthat management has an affirmative obligationin our economy to carry on operations andactivities so as to minimize all costs-to mini-mize the present value of these costs over thelong run. This is an obligation of managementto the stockholders and, indeed, to the compet-itive system, because to fail to minimize costsis to put a roadblock in the wonderfully effec-tive system of allocating resources by marketprocesses. This applies to tax costs as well asall other costs, and, except in a highly un-usual circumstance, tax costs are minimizedby taking depreciation as rapidly as legallypermissible.

Any management that fails to take deprecia-tion as rapidly as legally permissible to mini-mize the present value of tax payments isremiss in its responsibility to stockholders.This is something that must be done, and, infact, I would say that any management thatdoes not seek to maximize the present value ofthis stream of depreciation deductions is sus-pect in a sense and that we must look for theexceptional circumstances that justify this sortof procedure. In this connection, one of ourPh.D. candidates is writing a dissertationwhich is an effort to analyze firms that do nottake rapid depreciation for tax purposes to seewhat the unusual circumstances are which ex-plain their failure to do so. There is the ques-tion of what procedure does minimize thepresent value of tax payments. The tax lawspells out three general types of procedures-the straight-line method, the sum of the year’sdigits, and something described as double-declining balance. It is clear that either of thetwo latter, the sum of the year’s digits ordouble-declining year balance, will, almostwithout exception, give a more rapid rate of

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charge-off than the straight-line method. How-ever, the choice between these two, the SYDor double-declining balance, is dependent up-on several rather specific circumstances, suchas the estimated service life of the assets, thediscount rates that are appropriate for thefirm and the salvage value of the assets. Severalof us worked up a paper last year on the selec-tion of the optimal depreciation method in acapital-budgeting situation. This appeared inthe October Journal of Business.

Is there a danger that these goals of theleast and latest tax payments may conflict? Forinstance, in taking depreciation deductionsearly, may we be faced by the problem of in-creasing our tax payments in a later periodby a greater amount? You see, if we take moredepreciation now, then in a simple situationwe will have less to take later. If tax ratesshould turn out to be higher later, when ourtaxable income wouId be higher, we wouIdhave a larger total tax bill.

This might be the case if we were consider-ing a single-asset firm, although even here theinterest saved from postponing tax paymentsmight very well offset the higher paymentslater. However, if we move from a firm thathas only a single asset to the more realisticsituation of a balanced firm, the higher de-preciation on new assets that are acquired reg-ularly will serve to complement the lowerdepreciation on the older assets, with the re-sult there can be every expectation that thetax savings in the earlier years will not beoffset by higher taxes in the latter years. In-deed, if the firm is a growing one, there willbe more newer assets than older ones, with theresult that, rather than having repayments ofthe earlier tax savings, we will have increasingtax savings year after year.

If we turn from the notion of depreciationas a tax deduction to depreciation as a factorin external reporting, we are up against a dif-ferent sort of problem. In the tax situation theregulations are prescribed by the Internal Rev-

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enue Code. However, the place of depreciationin the external reports is prescribed by gen-erally accepted accounting principles.

The goal in the tax case is to minimize theoutflow of funds. The goal in the externalreporting case is to seek a statement of incomewhich is realistic in measuring the consump-tion of plant assets-one which is rational oraccurate in the measurement of the expirationof the plant assets. The only trouble is that noone knows how plant assets depreciate realis-tically, rationally, or accurately. In this calcu-lation we are faced with a multiplicity of sub-jective estimates. How long will the asset last?What is the pattern of its expiration of usefullife? What will be its salvage value?

Arthur Hadley, former president of YaleUniversity and a noted transportation econ-omist, once said, “God Almighty does notknow the cost of hauling a ton of freight fromNew York to Boston.” The same thing mightbe said with respect to what the realistic, theaccurate, depreciation charges are in any givenyear. However, it does seem to me that thereare some that are more realistic, more accuratethan others.

Recognizing that there has to be a consid-erable band of skepticism about any measure-ment of annual depreciation, yet we see somereason for feeling that depreciation should betied in with the capital-budgeting estimatesmade when we decided to buy the asset. Wehave another Ph.D. dissertation in processwhich seeks to analyze and describe the proce-dure of basing depreciation charges on capital-budgeting estimates of cash inflows. Whateverspecific procedures are used in measuring de-preciation, our goal in external reportingshould be to state, as realistically as possible,the amount of the expiration of cost of theassets used in operation.

What if this realistic estimate of expirationof costs differs from this maximum charge-offthat we seek under the tax laws? What if thecharge-offs for tax purposes do not coincide

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with what we think is appropriate for externalreporting purposes? There is some tendencyhere, I believe, to let tax rules be controllingand allow the possibility for more meaningfulincome reporting and more meaningful assetvaluation to go by the board-to accept thetax-depreciation charges. There is some ele-ment of clerical convenience in doing this, butthis impresses me as a minor advantage.

Far better, it seems to me, is to report in thefinancial statements the depreciation chargesin line with the best estimates of expirationthat we can make, based on generally acceptedaccounting principles, and simply allow thisfigure to differ from the one shown in the taxreturn. Since generally accepted accountingprinciples do limit depreciation to cost andsince we try to charge that cost off as rapidlyas we can for tax purposes, it is likely that theexternal reporting of depreciation charges isgoing to be lower than those shown for tax-reporting purposes. Therefore, we are likelyto show a greater income on our financial re-ports than we show on our tax returns.

This, it seems, is an altogether appropriate,permissible, legal, moral thing to do. Manyof my colleagues in the accounting professionsay that taking higher deductions for tax pur-poses today than we take on our financial re-ports means that in the future tax charges willbe based on a higher income figure than thatshown on the financial statement. In some fu-ture years, taxes will run more than 52 percent of reported financial income because inthose years there will be smaller depreciationdeductions to be taken, and so taxable incomewill run higher than reported financial in-come. This means, they say, that we haveborrowed tax deductions from the future andthat we should recognize something describedas a deferred tax liability.

I disagree emphatically with this view, butmy protests have had no effect. The AmericanInstitute of Certified Public Accountants andthe Securities and Exchange Commission now

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virtually require all firms, except some publicutilities, to recognize a deferred tax liability ifthey claim depreciation deductions more rap-idly on tax returns than in financial state-ments.

What is the nature of this deferred tax lia-bility? Will it require the expenditure of cor-porate funds at some future date, or is it, forall practical purposes, part of the stockholders’equity?

If a firm continues replacing assets, therewill always be as large a deduction on the taxreturn as in the financial records, with theresult that the deferred tax liability will neverhave to be paid. I have searched hundreds ofbalance sheets for evidence of payment of thisdeferred tax liability, and I have found nonefor the firms that have remained on an accel-erated depreciation basis for tax purposes. Iam not saying that there are no cases. It is justthat after hunting through a few hundredpublished balance sheets, covering a seven-yearperiod, I have not found any case where thisdeferred tax liability is drawn down, wherethe depreciation deductions on the tax returnare less than they are on the published state-ments. The reason, of course, is simply thatthis will come about only in the case of adeclining firm and one which is declining inthat happy state where its profits are remain-ing undisturbed through the liquidation pe-riod; this is somewhat hard to visualize.

Finally, what about depreciation in internalanalysis? There are a multitude of problemshere we could discuss, but we will skip overall but a few.

As far as investment decisions-certainly oneof the central problems in internal analysis-are concerned, what part does depreciationplay in the decision to purchase new equip-ment? It seems to me that, here again, thisdecision is affected only in terms of reducingcash outflow for taxes.

There is the myth that depreciation pro-vides funds for the replacement or expansion

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of capital assets. If depreciation is viewed asproviding funds, it ought to be sued for non-support as Charles Gaa says-there are no evi-dences that it is a good provider. The onlyway that funds are provided is by making salesto customers. Depreciation simply gives us atax shield so that less of the funds receivedfrom the customers need be turned over to thegovernment. Unfortunately, no amount of ac-counting legerdemain can produce funds. Itwould be wonderful for accountants if it werethe other way, if somehow by making a fewmarks on our books we could bring a substan-tial flow of funds into the firm. However,the only way funds can be provided is by find-ing customers willing to purchase our prod-ucts.

The central question regarding investmentacquisition decisions is whether the after-taxcash flow is sufficiently high to enable us torecover the cost of the investment plus a rea-sonable profit. The effect of depreciation issimply one of cutting down the tax out-pay-ments. This increases the rate of return; itincreases the excess present value; it shortensthe pay-back period. Whatever test is used forinvestment analysis purposes, the reduction oftax flow benefits it. That is the effect of de-preciation in this capital investment area asmeasurable solely in terms of the improve-ment in the amount of cash inflow that re-mains from sales to customers.

This is a point that has great relevancewhen we come to consider, as we will in a fewmoments, how changes in tax laws affect thevolume of capital formation in the economy.

One other place in internal analysis wheredepreciation has an important and growingsignificance is in measuring divisional per-formance. In this question of decentralizedoperations, which seems to appeal to peoplethese days (and with good reason, I believe),the question of depreciation and asset meas-urements plays a central role. One generalapproach to decentralized operations is to say

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that each division should show a satisfactoryrate of return; that we are willing to set thedivision managers up in almost a separate busi-ness if they will show a satisfactory rate ofreturn. This of course has to be a rate of re-turn based on some figure. The amount ofassets turned over to the division is the denom-inator of the rate of return calculation; theincome that the division earns is, of course,the numerator. Depreciation figures in thecalculation of both the income and the assetbase.

Most firms that I have been able to surveyfollow an arrangement that is similar to theduPont procedure, in which, as I understandit, the denominator is the original, undepre-ciated cost of the assets and depreciationcharges are taken as some percentage of thisoriginal undepreciated cost. A composite de-preciation rate is applied to this original un-depreciated cost. When we retire asset, nogain or loss is recognized. We simply reducethe asset total that is being charged off.

It seems to me that this approach, despite itssuccess, has several shortcomings. It gives apowerful incentive to retire assets prematurelybecause retiring an asset reduces the denom-inator. There is no point in keeping standbyequipment even though it may have potentialusefulness. As a matter of fact, this kind ofnotion would say that, if we bought a piece ofequipment last year for $100,000 which wethought would have a twenty-year life andnow this year a new piece of equipment comesalong that will save us $1,000 a year, we oughtto junk the old $100,000 piece of equipmentand buy the new one because by decreasingoperating costs by $1,000 it will increase theincome numerator and will have no effect onthe denominator, since both old and new equipment are carried at the original cost terms.Obviously, no division manager is going todo anything quite as flagrant as this. However,the plain fact is that this type of depreciationand asset valuation approach may very well

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serve to make the division manager’s interestsincompatible with those of the firm as a whole.

An alternative treatment would be to recog-nize losses on retirement of assets within thedivision. Of course, this tends to have theexactly opposite effect of making us unwillingto bring about retirements, even though theywould pay off in the long run. In the long run,of course, the division manager hopes he isgoing to be holding another job, and what heis going to be judged on are the profits of thisyear and the next.

What we need is a different approach, onewhich admittedly is followed by a great manyfirms, where what we do is to set up assets forthe divisions in terms of net book values-where we attempt an appraisal of the assets interms of their economic significance and thenkeep the record at cost from then on, with arevaluation every time we get a new divisionmanager. We would use composite deprecia-tion with no gain or loss recognized on dis-position of assets. This method also has short-comings; however, the fact is that there is noideal method of charging depreciation in adecentralized operation so that the divisionmanager’s goals and the goals of the firm canbe made to dovetail-all of such plans do havecertain drawbacks. However, it does seem tome that using depreciated economic values asa base, with a composite rate of depreciation,is probably the best way out of this difficultsituation.

What is the meaning of depreciation for theeconomy as a whole? Here, it seems to me, itsentire meaning is tied in with the tax laws.Depreciation has had a checkered history here.In the first English temporary income-tax lawof 1842, which has had its one hundred andtwentieth renewal this year, depreciation wasnot permitted as a deduction. In one of therenewals of the temporary law, that of 1878,provision was made for permitting deprecia-tion of equipment and machinery.

Our own 1894 law, which was ruled uncon-

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stitutional for other reasons, specifically dis-allowed depreciation as an income-tax deduc-tion. Almost all the twentieth-century laws,including our own, have contained a provi-sion which does permit depreciation as a taxdeduction. The idea has been that this isnecessary in order to get an equitable measure-ment of income and also that it does have aneffect upon economic growth.

Since World War II, almost every countryhas tinkered with the depreciation provisionsof its income-tax laws in an effort either tomake the laws more equitable or to stimulateeconomic growth. Of course, it is difficult toseparate the two because any changes made inthe name of improving equity usually speedup the rate of depreciation deductions for taxpurposes. This simply frees funds and makesinvestments that much more profitable, eventhough it is done in the name of equity ratherthan in the name of economic growth.

However, one thing we have discovered isthat it is far easier to get tax changes throughif they are offered in the name of equity thanif they are put forth with the suggestion ofsecuring a greater rate of economic growth.Indeed, within the next month or two, theTreasury Department will issue what amountsto a revision of Bulletin F, which sets forthestimated service lives of assets generally. Theamendment will shorten by some 20 or 25per cent the service lives over which depre-ciation can be taken for tax purposes. This isa measure that is likely to win almost unan-imous approval because, by and large, it isdone to make the tax law more realistic, moreequitable.

It is estimated that this will cost about abillion and a half dollars in tax revenues inthe next fiscal year, but, because this is donein the name of equity, everyone is pleased andhappy with it. Similarly, the 1954 provisionfor acceleration of depreciation was offeredlargely in the name of equity and, as a result,met fairly general approval.

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When we turn to the question of deprecia-tion deductions for tax purposes as a meansof stimulating economic growth, it seems tome that we run into a greater controversy. Ourearlier analysis in this area still holds-theonly way that depreciation can stimulate eco-nomic growth is by altering the time patternof tax charges by permitting the firms to defer,in most cases indefinitely, a substantial amountin tax payments. This has the effect both ofmaking the firm more liquid-therefore betterable to carry on investments-and of makingindividual investments that much more profit-able. It increases both the desire and the abil-ity to carry on capital formation.

To this end, the President has, within thelast year, put forth a proposal for investmentcredits-a proposal that firms be permitted acredit of 7 per cent of their investment in eli-gible assets against their income-tax payments.The original proposal was 15 per cent, withsome adjustments. Then it was reduced to 8per cent. Finally, we now have it down to atax credit of 7 per cent of the amount of eli-gible investments.

In explaining the tax credit proposed, Sec-retary Dillon said:

“As we look back over the past century wesee that our record of economic growth hasbeen unmatched anywhere in the world. Butof late we have fallen behind. . . . In the lastfive years Western Europe has grown at doubleor triple our recent rate and Japan has growneven faster. While there is some debate as tothe precise annual growth rate of the Sovieteconomy, CIA estimates that their GNP grewat a rate of 7 per cent in the 50’s. Clearly, wemust improve our performance, otherwise wecannot maintain our national security, we can-not maintain our position of leadership in theeyes of the world and we cannot achieve ournational aspirations. The pressing task beforeUS, then, is to restore the vigor of our economyand to return to our traditionally high rateof economic expansion and growth. I am con-

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fident this can be accomplished. But it willrequire a major effort by all of US.

“I have been impressed during recent trav-els abroad by the great progress our friendsoverseas have made in reconstructing theireconomies since World War II and by thehighly modern and efficient plants they nowhave at their disposal. . . . I think it importantto emphasize that it was due in good part tothe vigorous policies of the European govern-ments. Tax incentives for investment playeda significant role, including accelerated depre-ciation, initial allowances and investmentcredits.”

The Secretary says that the way to get themore rapid rate of economic growth that wewant is through this expanded scheme of taxcredits.

Now, in considering depreciation reform forgrowth purposes, I think there are severalquestions we want to ask.

The first of these is: Should we tamper withthe “natural” rate and the structure of growththat is produced by market forces?

Then, if, through the orderly operation ofmarket forces, we are growing at a 3 or 3 1/2per cent rate, should we, by means of a de-preciation device, tamper with this naturalrate of growth?

Further, if we do tamper with it, will depre-ciation reform give us more capital investmentand, therefore, more growth?

Finally, if depreciation reform increasesgrowth, is the investment credit proposal nowbefore Congress the most efficient way ofachieving the growth? Can we get more growthper dollar of tax revenue foregone by this de-vice than any other?

I am willing to confess that my general an-swer to all of these questions is “Yes.”

I think that the question of what a naturalgrowth rate is depends to some extent uponwhat we have said about depreciation deduc-tions in the tax law-that our natural growthrate of 3 1/2 per cent over the last decade or so

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has been related to the way firms have hadcash taken from them through taxes, whichwas affected by the depreciation pattern per-mitted by the tax laws. However, I am notabout to say that a 7 per cent investment cred-it is the kind of natural force that wouldemerge if we sought a realistic measure ofdepreciation. It does seem to me that there isa sound basis for feeling that a more rapidrate of growth is desirable and possible, thatpositive government efforts to help secure itare appropriate, and that this can probably beachieved as readily through depreciation re-forms as through any other means.

If the way to get a more rapid rate of growthis to increase and to modernize productive fa-cilities, depreciation reform has the virtue ofsingling out this area of growth, this particulararea of expenditure, for special treatment,with the result that we do minimize tax lossin arriving at this growth area.

This may bring about some distortions with-in the economy. Dean Wallis, in a recentspeech on automation, pointed out that struc-tural unemployment may result from usingtax gimmicks to stimulate new investmentsbefore they are called for by relative wagerates; that the effect of cheapening capital(which is what this tax gimmick does) is tostimulate the use of capital in place of labor,which may cause some unemployment. Thereis no way to deny the logic of this argument.The only question is: Is this a sufficientlysmall price to pay to get a more rapid rate ofgrowth?

What about investment credit as a devicefor bringing about growth at a minimum cost-a minimum cost to the Treasury? By thisdevice we are focusing not only on capitalformation but also on the effects in the firstyear. The investment credit says that in theyear of acquisition we get a credit amountingto 7 per cent of the cost of the asset. Now, ifwe were to spread this out over a period ofyears, it would mean that the amount of sav-

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ings to the firm would have to be substantiallygreater in order to secure this same effect. Inany system where money has a positive timevalue, the more of the special deduction wecan put in the first year, the greater its effectis going to be. Further, the only way thatdepreciation affects the capital investment de-cision is by affecting the cash outflow; if wecan affect the first-year flow, we will get amaximum result.

It is true that the investment credit for thefirst time provides for a breach in the taxprinciple which says that depreciation, as infact all expenses, is limited to the amount ofdollars expended. The investment credit is inaddition to regular depreciation so that youcan get 100 per cent of the cost of the assetcharged as a tax expense over the years and,in addition, get the 7 per cent tax credit. Imust confess that I have some misgivingsabout this aspect. However, in comparing itwith the alternative that would produce aboutthe same amount of tax savings, a 40 per centcharge-off in the first year, it seems to me thatthere is much to be said for it. To summarize,my feeling is that depreciation reform can bemade a part of an appropriate policy to in-crease the rate of economic growth. Deprecia-tion has a significance to the firm in terms ofits cash flows and to the economy as a wholein terms of affecting the rate of growth.

Thank you very much.

DEAN WALLIS: Mr. Davidson has promisedto deal with questions, and, of course, whileeverything he says always sounds completelylucid and sweetly reasonable to me, I do findthat it often starts a riot among people whoknow something about the subject. Therefore,let us see who has the first question.

QUESTION: Professor, you said something atthe outset that interested me. You said thatdepreciation did not provide cash for futurepurchases. However, in the light of what you

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said later, I do not think you meant thatexactly as it sounded.

You know, of course, that a banker alwayslooks at cash flow. When a banker makes aloan, he lumps the net profits after taxes andthe depreciation to show the cash that wouldbe available to repay his loan.

I am now thinking of a case where a cos-metic company was purchased for $5 millionwith no cash equity whatsoever-it was alldone on borrowed funds. However, the com-pany was able to depreciate its patents andcopyrights at rates of $78,000 a month, result-ing in profits the first year of $1.8 million.Therefore, in three years enough cash accumu-lated to pay off the loans made on behalf ofthe company.

Would you care to comment on that?

MR. DAVIDSON: The whole secret is that thecompany was doing something besides charg-ing depreciation. I would suggest to you thatthey would not have been able to pay any-thing off to anybody if they had not been outthere on the street selling cosmetics to ladies.

QUESTION: Well, they made $1.8 million thefirst year-but then a million of that was de-preciation.

M R. DAVIDSON: Indeed, the significant thingabout depreciation is its effect on taxes. Thecompany must have made $4,600,000 beforetaxes and depreciation. By virtue of the factthat they could charge a million dollarsto depreciation, their income before taxes was$3.6 million. Therefore, they only had $1.8million of taxes, and the rest was cash flow.

All that I am saying is that you can get cashin this way. In order to do this, you do notneed to hire the best accountant in the worldto set up a scheme of depreciation for you.The way to get the cash is to sell the cosmetics.The only way that depreciation helps you inthis area is by reducing your cash outflow fortaxes. We accountants, and financial analysts

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as well, have contributed to the confusionabout cash-flow procedure that you suggest, byadding depreciation charges to net income inour statements of funds.

Far more satisfactory would be a procedurewhere we deduct the expenses that use cashfrom the amount of revenue from customersand show cash flow the way we really get it.Unfortunately, however, most fund statementsare not presented in this fashion.

QUESTION: I believe you talked about depre-ciation for tax purposes and for income pur-poses as well as depreciation for the growth ofthe economy. What depreciation would yourecommend using, first, in establishing prices,if you can establish them; second, in deter-mining whether a particular commodity orservice is profitable; and, third, in what youpay out to security holders based on depre-ciation of original costs-which factor wouldyou use in those cases?

MR. DAVIDSON: The question is: How doesdepreciation figure with regard to the settingof price for the product, in determining profit-ability of a product line, and, finally, in rela-tion to dividend policy.

Well, with the exception of the public utili-ties that are here represented, it does not seemto me that depreciation plays much of a partat all in the setting of prices.

When the plant is acquired, you make cer-tain assumptions about what your total out-put will be over the life of the plant. Youmake certain assumptions about what yourincremental operating costs are going to be.You likewise make certain assumptions aboutwhat your unit sales are going to be and priceis set on a long-run basis.

If market forces permit you to charge thiskind of price, that is one thing. However, onceyou have made the investment, all the calcu-lations are meaningless. Then what you wantto do is to get as much as you can from theequipment without regard to what your de-

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preciation charges are. If, in order to get ridof the product, you have to sell it so that youmake only a very minor contribution to thecovering of this fixed cost, you will do it-atleast you ought to do it.

There are some horrible examples you hearof, like the ice-cream manufacturer who hadan enormous warehouse empty during mostof the winter months. Someone wanted to renthis cold-storage facilities for storing turkeysfor Christmas. He decided that, although therewas almost zero incremental cost in rentingthe facilities, he would not rent unless thetenant agreed to pay the full depreciationcharges. The deal fell through. The ice-creamman lost a fine chance to augment his income.This I think is the heart of the relationship ofdepreciation to the whole pricing problem:Except for the regulated industries, deprecia-tion, I feel, probably plays virtually no part inthe pricing decision.

Now, of course, if you are in a semiregulatedindustry, such as steel, the question of costjustification enters. However, where you donot have to justify costs to an outside agency,I think it plays no part.

Insofar as individual product profitabilityis concerned, here again we must decide wheth-er to go into the manufacture of this productand purchase a large amount of equipment.Once the equipment is committed, again itseems to me that it is the direct costs that arethe all-important ones. Probably, in deter-mining product profitability, we will includea depreciation charge; however, I favor in-cluding it below the line, where the line rep-resents contribution toward the meeting ofdepreciation and contribution toward profitof the firm.

With respect to the dividend question, here,I think, depreciation may play a greater part.Legally, of course, we are estopped in almostevery jurisdiction from declaring dividendsunless we do have some income, and this in-come is income after maintaining capital and

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after charging depreciation. In this sense wemay get some cash contribution through thedepreciation charge because it keeps us fromdeclaring as much in the way of dividends aswe might otherwise declare.

QUESTION: I detected something in your re-marks that indicates that you have the tradi-tional accountant’s viewpoint: There is a littlebit of sin in recouping more than the originalcost value in depreciation, in spite of the factthat we have been in continuous process ofinflation.

M R. DAVIDSON: The question is whetherthere is something sinful in recouping (and Iassume you mean for tax purposes) more thanthe original cost in the depreciation process.

Well, again, what you recoup depends uponhow much you can get your customers to pay.In determining the prices that you charge foryour products, it would seem to me that thecompetitive society could not function well ifyou did not take into account current replace-ment costs. The depreciation question merelyasks how much of what we get for selling cos-metics is going to be reported as depreciationand how much as income.

Now, with regard to the tax situation, thisis a very real problem because how much youreport as depreciation and how much you re-port as income is going to affect the amountof taxes you pay.

There has been, as I am sure you are allwell aware, a great deal of controversy abouttaking current-cost depreciation rather thanhistorical depreciation on tax returns. Con-gress, very wisely-at least in my opinion-hasstuck to the historic cost limitations in depre-ciation deductions. However, if price-levelmovements should become more violent, thenwe might adopt a current-cost depreciationdeduction. This should be done not only withrespect to depreciation but also with respectto all items of income. That is, the interest re-ceived should be adjusted in terms of the rela-

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tionship of the purchasing power of the inter-est received compared with what was promised.Further, in all aspects of income we ought togo on to a current-cost basis. Until we permitcurrent-cost adjustments for all items, it mightbe more equitable not to permit current-costdepreciation.

As far as financial reporting is concerned,there is a whole host of problems involved incharging current-cost depreciation, includingthe same question of the kind of mixture ofmeasuring units that should be used in theentire accounting system. If we are going tosay that our unit of account should be somequantity of purchasing power for all items,I would be much more sympathetic.

QUESTION: Basically, there is a lot of con-cern today about reporting to stockholders onthe basis of current-cost depreciation and pay-ing taxes on the other basis because manage-ment does want to be honest with stockhold-ers. Therefore, if it is honest as far as stock-holders are concerned, then it is likewise hon-est as far as earnings are concerned. Wouldyou care to comment upon that?

MR. DAVIDSON: This reporting of deprecia-tion on a current-cost basis is more commonlyfound in the President’s letter than in theformal statement of accounts.

QUESTION: Do you mean they lie a little?

MR. DAVIDSON: No, I do not mean that atall. I am just saying that generally acceptedaccounting procedures do not permit you totake depreciation on anything but an originalcost basis, so the published financial state-ments will in every case carry an exception ifcurrent-cost depreciation is used. However, thePresident in his letter may very well say some-thing else.

QUESTION: Do you refer to a separate reserveitem?

MR. DAVIDSON: Yes.

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I do not, I confess, feel that we would in-crease the over-all equity or effectiveness ofthe income-tax law by permitting depreciationin terms of replacement costs while denying itin other areas. However, this is not an opinionthat is universally held.

QUESTION: I believe you indicated that theSecretary of the Treasury said that the reasonfor this change in depreciation policy was pri-marily to help stimulate our economic growthby modernizing our plants so that we cancompete in foreign countries and with foreigncompetitors. What I object to is this indirectapproach we are using.

After all, Uncle Sam is now the greateststockholder we have in connection with anycorporation. He receives 52 per cent of theprofits. Now, then, we have through our taxstructure taken 52 per cent of these profits andsubsidized certain parties in various countries.We have put ourselves in this competitive po-sition. The question I am raising is: Why dowe use the indirect approach of saying thatdepreciation reform will stimulate economicgrowth? Why do we not use the positive ap-proach? Why do we not reduce taxes from the52 per cent rate to the 40 per cent rate so thatour cost of operations can be lowered; so thatthe steel companies can compete with foreigncompanies? Is this not a direct approach?

MR. DAVIDSON: Of course. It is almost toodirect, and that is the trouble.

We also have the problem of somehow fi-nancing government activity without bringingabout too great an excess of expenditures overreceipts and thereby contributing to an infla-tionary process. It seems to me that what wehave to do is to ask how we can get growth;how we can get modernization; how we canget new capital formation with a minimal lossof revenue to the Treasury.

Now, then, the main fact is that, if we wereto cut income-tax rates instead of giving aninvestment credit, it would take, in terms of

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effect on investment decisions, about a 14 or15 per cent cut in the tax rate, for an assetwith a service life of fifteen years, to equal theinvestment credit. That is, we would have tocut taxes back to 38 per cent before it wouldbe as profitable for a firm to buy a new assetas it would be if we gave them a 7 per centtax credit. The main fact is, in my opinion, wejust plain cannot afford a 14 per cent reduc-tion in the corporate tax rate. Therefore, whatwe want to do is get as much of increase incapital formation as we can with a minimumloss of revenue to the Treasury.

What I would dearly love would be to seesomeone come up with an arrangement wherewe could say that only investments that wouldnot be made without some form of investmentcredit would receive the credit. Unfortunately,however, nobody will confess that his is aninvestment he would have made even if therewere not an investment credit. As you willrecall, the Administration had the notion ofsaying that only investments in excess of de-preciation allowances would qualify to get awhopping big credit in order to stimulategrowth. However, there were sufficient diffi-culties involved so that the Administrationfinally withdrew the plan.

QUESTION: A month or so ago, in this sameclub, David Bell, in an informal talk, com-mented on stimulating growth. However, hisapproach involved not only stimulatinggrowth but controlling growth. If we get intostimulating growth through tax credits andthrough changes in depreciation rates, I won-der whether the next step will be to use this asa means of controlling growth when it seemsto be going too fast to suit the director of thebudget.

MR. DAVIDSON: Or to please the Congress,really, because it is they who must enact thelegislation. However, you are right-the his-tory of depreciation reform has seen these upsand downs. As a matter of fact, each year in

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the renewals of the temporary income tax lawin England, they do lay down different depre-ciation regulations, depending upon theamount of growth that is sought for that year.Further, Sweden had 100 per cent write-off formore than a decade and a half, until Swedendecided this was giving the country too muchgrowth and inflation, so this sort of thing wascut back.

You are also right in saying that this is apolicy that can be used, I think, both to stim-ulate and to control growth and like any gov-ernmental policy which seeks to depart fromnatural economic forces, it does confer on po-litical authorities some degree of control overimportant economic questions.