tries knows that a stone worn to one-half its original diameter is not worth full price. One may argue that it has had good care, that the bearings have been well lubricated, that it will sharpen shears as efficiently as a new stone, and that the purchaser will be able to replace it when it is worn out, but he can convince no grinder that it is worth as much as a new stone. There is no magic about street railway operation that differentiates cars, track, buildings, etc., from ordinary property, and everyone knows that practically all mechanical devices. decrease in value with age. To accept the theory of the applicants requires that one believe that property has full value up to the very moment it disappears, and then instantly drops to zero. Further, if parts of an undertaking deteriorate and decrease in value, the whole undertaking will not have a value equal to its original cost unless all of the parts are new. Replacement of parts-that is, cars, track, boilers, engines, etc.-as they need replacement will not keep the property as valuable as when new unless the parts are all replaced at once, which is practically impossible. The only way to determine what is the value of the whole undertaking is to examine its various constituent parts and determine their value, having regard for all of the factors. Re Third Avenue Railroad Reorganization Plan, 2 P. S. C. 1st D. (N. Y.) —, decided July 29, 1910, is also a capitalization case. In delivering the opinion of the Commission in this case Commissioner Maltbie speaks of the effect of depreciation on value as follows: It is also argued by the applicants that a plant, which is in first class operating condition, although its cars may be somewhat old, its rails worn and its machinery aged, is worth as much from an operating point of view as a plant which is practically new throughout. They doubtless mean that such a plant can earn as much as one which is practically new and represents in value 100 per cent. of its cost of reproduction. . . It may be that from a gross earnings point of view a system whose present value is equal to 75 or 80 per cent. of its cost to reproduce new is nearly equivalent to a system whose present value is 100 per cent. of its cost to reproduce new; but there are several considerations which prevent the complete acceptance of this theory when applied to net earnings. The cost of maintenance and repairs is less when a road is entirely new than when it is 75 per cent. new. Plant and equipment become less efficient with age. But most important of all, the period is shortened within which provision must be made out of earnings for renewals, replacements and reconstruction. . . . It was admitted by witness Floy that an old road could not be sold for as much as a new road, and that is practically the question at issue here, for the property of the old company is to be acquired by purchase by the new company. § 450. Definition. CHAPTER XIX Functional Depreciation 451. Ordinary functional depreciation. 452. Extraordinary functional depreciation. 453. Functional depreciation actually accrued should be deducted. 454. Functional depreciation deducted in Holyoke, Mass., Purchase Case, 1902-Report of appraisers. 455. Hypothetical functional depreciation. 456. Hypothetical depreciation disallowed in New York City Eighty Cent Gas Case. 457. Hypothetical depreciation apparently allowed in Washington ap praisals. 458. Treatment of past losses due to supersession. 459. Problem of past supersession discussed by Henry Earle Riggs. 460. United States Circuit Court in Des Moines Gas Rate Case, 1896— Investments in unsuccessful experiments excluded. 461. United States Circuit Court in Milwaukee Street Railway Fare Case, 1898, holds superseded horse car equipment entitled to equitable consideration. 462. United States Supreme Court declares that past supersession may not be included. 463. Street railway supersession excluded in capitalization case-New York Public Service Commission, 1910. 464. Supersession due to consolidation-Wisconsin Railroad Commission, 1911. 465. Casualty. $450. Definition. Functional depreciation has already been defined (above, § 391) as lack of adaptation to function. It results from changed conditions and surroundings which render the structure ill adapted to its work. It may be due to the growth of business which renders the structure inadequate or to the development of the art which renders it obsolete. The replacement of structures that have become ill adapted to their work is termed supersession. Supersession is the discarding of a thing before it is worn out. The thing discarded may have become inadequate to meet the demand for increased service or have become obsolete owing to the discovery of better or cheaper methods. § 451. Ordinary functional depreciation. The approaching inadequacy of an existing distribution system or other facility can usually be foreseen and provided for by means of a reserve fund. Changes in the art that will render some particular motor or other part of the equipment obsolete cannot be foreseen. If the art is in a developmental stage we may be sure that there will be numerous changes and a considerable loss from functional depreciation, but where the changes will come and what portions of existing equipment and construction will be affected is purely guesswork. This hazard of becoming obsolete is like the fire hazard. Each building is in danger of burning and we can be sure that at least a certain number of buildings will burn each year, but any particular building may stand for centuries. Each particular article of equipment is in danger of becoming obsolete and we can be sure that at least a certain number of such articles will become obsolete during the next decade but any particular article may perchance never be superseded. The company may and should guard against functional depreciation by keeping a reserve fund based on the stage of development of the art and the rapidity with which changes have come in the past. Such a reserve fund is necessary in order that the capital may be kept unimpaired. All expenditures necessary to keep the capital intact are operating expenses and come before dividends and even before interest. If this is not done, dividends are paid not out of earnings but out of capital, which is contrary to the first principles of correct accounting and sound finance. This is recognized by all uniform systems of accounts prescribed by governmental authority. The capital account can not remain charged with the cost both of the new thing and the thing it superseded. Normal supersession must be provided for out of earnings if the enterprise is to continue as a going concern. If low rates of charge or the payment of unearned dividends prevent this the ultimate result is financial disaster. § 452. Extraordinary functional depreciation. But there may be extraordinary supersession for which in particular cases there may have been no opportunity to provide by means of an accumulated reserve. A new invention may so revolutionize methods of production as to require the scrapping of practically the entire plant. This is a possibility that while recognized is not provided for by means of a reserve for the amortization of existing capital. The difficulty is that this complete plant supersession may come in five years or in fifty years or perchance not at all. There is no more telling when it will come than when fire will destroy a particular building. The hazard of complete supersession is greater for some enterprises than for others just as the fire hazard is greater for some buildings than for others. It is as difficult for a public utility plant to provide against this sort of supersession as it would be for the owner of a single building to carry his own insurance. There are no supersession insurance companies and there is no probability that they will or could be developed. However, if there were such companies the annual premiums for supersession insurance could be charged to operating expense in the same way that fire insurance premiums are now so charged. This would take care of the supersession hazard. As it cannot be thus shifted it must be borne directly either by the investor or by the consumer. Ultimately in any case it |