Static Depreciation in a Dynamic Economy CHARLES
S.
MUNSON,
President, Manufacturing Chemists' Association, Inc., 246 Woodward Bldg., Washington, D . C.
S p e a k i n g hefore the a n n u a l m e e t i n g of t h e Manufacturing C h e m i s t s 9 A s s o c i a t i o n , t h e a u t h o r p o i n t s o u t t h e p i t f a l l s o f wishf u l t h i n k i n g o n t h e s u b j e c t of d e p r e c i a t i o n r a t e s . . . D e s p i t e an emphatic " N o ! " f r o m accountants and the Government, a r e v i s i o n o f p r e s e n t - d a y d e p r e c i a t i o n rates a p p e a r s i n o r d e r .LAST year, you may recall, my remarks on this occasion reflected our concern over the shortage of equity capital. The constantly growing demand for the products of our lusty, but still infant, industry was reviewed. The need for investment in new facilities, the tremendous burden of fixed debt being incurred because of the scarcity of venture funds, and the tax reforms needed to correct the evil conditions that existed were identified. Our concern was fully vindicated by subsequent developments in 1948. More than S17 billion was invested in plant and equipment during the year by all industries. Only 7% of this amount came from new stock issues. Long term borrowings accounted for 35%—five times as much. The bulk of the funds—58%— came from such internal sources as depreciation accruals and undistributed profits. Fortunately, the 1948 profits, as reported by conventional accounting methods, seemed large enough to bear the burden. They stood at a record-breaking level of $21 billion after taxes, according to latest Department of Commerce estimates. Profits Overstated by Present Accounting Methods But this dollar figure., as all of us have come to recognize, grossly overstates the real profits earned. It is a paper figure only. , I t includes dollars which have already been spent to replenish inventories at today's higher costs. It includes dollars which must be reinvested simply to replace existing facilities as they wear out since normal depreciation charges are grossly inadequate in the face of today's high prices. As long as these higher costs persist, it manifestly will be impossible to maintain our existing plants and equipment through the reinvestment of the same number of dollars that went into them originally. More dollars must be accumulated out of the proceeds from curVOLUME
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rent production, or we face a gradual erosion of our entire productive machine. Such a deterioration in our productive capacity would be a body blow, not only to America's living standards, but to the very future of our free civilization. For without the deterrent of America's industrial supremacy, the cold war could easily turn into an inferno overnight. Dr. Slichter of Harvard indicated the magnitude of the problem in his testimony last December before a Congressional committee. Out of reported profits of $51 billion in the three years 1946-48, he estimated, true corporate earnings totaled only $34 billion. The remaining $17 billion went into inventories and capital replacements. They were just as much a part of the cost of doing business as last week's payroll or last month's payments for raw materials. Industry, however, paid income taxes on the $17 billion of paper profit as well as on the S34 billion truly earned. In this sense, today's corporation taxes actually have become a disguised levy on the capital of the country. In addition to being victimized by the tax collector because of this overstatement of its profits, management has been subjected to many other forms of economic pressure. The public complains that prices are too high; stockholders feel that the percentage of earnings distributed as dividends is far too low; and employees argue that wages can be raised without advancing prices. Demagogic politicians rush into the headlines with demands that "exorbitant" profits be taxed away. And management itself, unless it makes a conscious adjustment in its own financial figures, may be misled as to the success or failure of current operations and may find itself planning unsoundly for the future. Fully cognizant of these problems, several leading corporations endeavored as early as 1947 to reflect current replacement costs in their depreciation charges. This, it seeined obvious, would result in a more reliable picture of true earnings » JUNE
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during the year. The history of these efforts is too familiar to most of you to justify repetition in detail. You know that the Bureau of Internal Revenue, the SEC, the American Institute of Accountants, and even the Stock Exchange, all said, " N o ! " These quarters insist that depreciation allowances must be limited by the dollars of original cost, no matter how much may be required at today's price levels to replace the facilities when they are exhausted. Operating within the framework of this limitation, a significant number of corporations provided for some form of accelerated depreciation in their 1948 income statements. There can be no assurance that all such accelerated amounts will be recognized for tax purposes. But at the minimum they help to present a picture of net income to stockholders and others that is more in line with the economic realities of the day. Accelerated depreciation, however, is still the exception. The more frequent procedure is to report net income on the traditional basis, and then to appropriate out of surplus a sum deemed sufficient to provide for the higher replacement costs anticipated. Few businessmen are genuinely satisfied with this procedure. Reserves of this character are not tax-exempt, which means that industry must pay $38 i n taxes for every $62 it earmarks in this fashion. Net income is still reported a t overstated levels. Indeed, creation of such special reserves performs no useful function except to help dramatize, to stockholders, one important reason why the total amount of earnings is not available for distribution as dividends. Just where does this leave us? "While there is by no means any unanimity within the accounting profession, there is no sign of any weakening in its official position. In fact, earlier this year the Herald Tribune noted that After consideration of all the discussions . . . .the accounting profession as a whole has become more convinced than ever that individual companies should not take upon themselves to charge (supplementary depreciation) items against net profit In the absence of such professional endorsement—or even if it could be secured —there is a moral certainty that the tax authorities would not accept deprecia1789
tioii revisions initiated by management itself. For any real relief, therefore, Congress must act. Surprisingly enough our legislators— even the left-wingers among them—seem far more sympathetic to such changes than do^ the accountants who so frequently .have been criticized as being subservient to the inckistries that hire them. A few years ago, for example, Henry Wallace advocated a general increase to 209& in depreciation rates. Franklin Roosevelt, shortly before his death, also urged accelerated depreciation as an encouragement to business "to expand its plants and to replace its obsolete and worn out equipment." Even the more extreme of today's Fair Dealers also have indicated a willingness to consider depreciation legislation in 1950. Deficits Will Handicap Legislative Efforts This sympathetic attitude, however, will not be transformed into legislative actuality without concentrated and wellorganized efforts on the part of business. A new political hurdle has arisen in the form, of a prospective federal deficit. What a frightening thing that is: a deficit at the peak of peacetime prosperity! Any attempt now to reduce the number of tax feathers plucked from the industrial goose is doomed to failure unless the public benefits have been made crystal clear, not only to Congress but to the entire voting public. At the moment, industry's thinking has not crystallized to a point where it could sustain any vigorous educational campaign of this nature.· There are as many recommended answers to the problem as there are people who talk about it. No real progress will be possible until this babble of voices can be harmonized into a mighty chorus demanding action. Many of our conflicting ideas, it seems to me, could be reconciled quickly if we were only more confident of the future trend of prices. Our expectations in this field necessarily color our judgment on the legal, tax, and accounting adjustments deemed essential. / / Prices Continue Upward I t is argued by many that political morality in our nation has sunk so low that we must reconcile ourselves to a federal policy of permanent inflation, in good times and in bad, and regardless of the party in power. At a minimum, they contend, we have reached a new "plateau" in prices from which we will never again recede. If this prognostication of the future is accepted, industry must insist unequivocally that depreciation allowances be calculated on the basis of replacement costs. Any lesser remedy might meet the immediate problem but still leave us defenseless against an inflation of the future. But can we be sure? The same 1790
prediction of a "new plateau of prices" has been advanced after each wartime inflation this nation has experienced. Each time the prediction has been wrong. After each war, prices have returned— for a while, at least—to prewar levels. There is a real vitality to a free market economy which can not long be denied. It can happen here again, despite all the political pressures, the organized strength of labor unions, the financial burden of the national debt, and the other inflationary factors often cited. If prices should go down substantially, we may find that we do not love the replacement value theory in December as we did in May. If prices recede, depreciation based on replacement values would fail to recapture the original cost of the postwar investments made during the past four years. Indeed, under certain price conditions, we might accumulate reserves in excess of replacement costs, in which case we would have to credit current income with the excess and pay out taxes on this bookkeeping entry. It is easy to say now that we would be perfectly willing to take the bitter with the sweet But will we think that way a few years hence? If Prices Fluctuate If the price picture is to be as flexil le as history suggests, then it seems e\ ident that our answer to the problem of replacement capital should rest upon an equally flexible foundation. And the logical way to do this, even under the "original cost" concept, is to provide greater latitude to management in determining the rate at which this total allowable amount may be depreciated. This is not as revolutionary as it may sound to those steeped in the "original cost" tradition. Sweden, for example, permits complete freedom to the owner of a capital asset. H e may depreciate it in 1 year or in 20. England permits a write-off of 40% during the first year, with subsequent annual depreciation allowances of 12.5% of the remaining cost. In both countries, these liberal policies have been both popular and economically successful. A great variety of similar proposals are being advanced here in the United States. Roswell McGill, former Under Secretary of the Treasury, has pointed out that the present law instructs the Commissioner of Internal.Revenue to recognize "a reasonable allowance." He continues, "That wording surely permits the revenue agent to allow the company's [own] depreciation rates to stand, unless they are way out of line, and certainly at least a 50% margin over generally approved rates should be regarded as reasonable." The American Institute of Accountants has publicly urged approval of a 25% leeway from the standard rates now recognized by the Internal Revenue Bureau. CHEMICAL
Other proposals have been advanced by the Machinery & Allied Products Institute, by Ben Moreell, president of Jones & Laughlin, and others. Without going into detail, these have the common characteristic of accelerating depreciation on the basis of some predetermined formula that would be authorized by law. Still another school of thought concedes that accelerated depreciation would be of vital importance to the economy, but proposes that the Government offer it as a special "bait," for a limited period only, at the exact period in the business cycle when it would be most helpful. This is an intriguing approach in many ways. One wonders, however, just who would decide that we had reached the "exact point" in the business cycle when the remedy should be applied. Would it be the same government officials who predicted that 8 million would be unemployed within a few months after V-J Day? Or who argued, even within the last 60 days, that inflationary pressures were still increasing rapidly? No, if discretion is to be exercised in the "timing" of depreciation charges, the nation would be better served by vesting that discretionary power in private hands. Statesmanlike decisions would be required, it is true, but I have faith that the majority of businessmen would make them. And even if a few guessed wrong, it could not cause the economic damage that would result were the Government to force a wrong decision down the throat of our entire economy. Current Managerial Decisions Required JLet us assume for a moment that all these uncertainties have been resolved; that a generally accepted revision in accounting practice has been devised ; and that Congress has been persuaded t o sanction it by law. Will our problem then be over? As Captain Andy of "Show Boat" fame would say: "Folks, this is ONLY the beginning!" Management must guard against the tendency to think that accounting reforms alone can provide an automatic answer to today's depreciation problems. Supreme Court Justice Jackson noted in a recent opinion: Even as a recording of current transactions, bookkeeping is hardly an exact science.... Few concerns go into bankruptcy or reorganization whose books do not show them solvent and often even profitable... .However, our quest for certitude is so ardent that we pay an irrational reverence to a technique which uses symbols of certainty, even though experience again and again warns us that they are delusive. Accounting techniques in themselves are not conclusive. They neither add nor subtract one dollar from the funds available for replacement purposes. No matter how improved, they can offer AND
ENGINEERING
NEWS
uothing but general guidance for the exercise of managerial judgment. Proper accounting will indicate the price level needed to recover our actual costs of operation, but it will be the pressure of competition and our own managerial judgment that must determine t h e prices actually to be charged. Proper account ing can report the funds available for reinvestment, b u t only management can determine when and how the investment should be made. Proper accounting can give useful tools with which to interpret our operations t o our stockholders, our employees, and to the public. But it will take a method of communication that is far more humanized than the
balance sheei r.o win the public favor that we need. I n t h e last analysis, as is true in so many of today's industrial problems, public opinion is going to provide the final answer. The endorsement of the accounting profession, the tax collector, and the SEC will be essential, but their benediction will prove meaningless unless the public, too, approves. If our motives are trusted, if our ob jectives are approved, and if our sem?p of trusteeship is recognized, then WP will have the public support we need in this endeavor. But if we are suspect— if the opinion develops that this is
