gree. If that be the case it may be considered wise simply to set aside a certain sum for the purpose of providing a fund out of which to meet depreciation when such depreciation is recognized in the future or when it has gone to such a point that it can be accurately measured. In this case the concern may simply determine to lay aside a more or less arbitrary sum out of profits with which to meet possible future depreciation. We may assume that at the end of the year an expert man goes through the plant and comes to the conclusion that the probable annual depreciation will be about $450, although he feels uncertain as to precisely how much should be assigned, say, to plant or fixtures. Some of the considerations affecting his judgment will be sketched later. At this point it may be assumed that his judgment is taken as sufficiently accurate. The concern determines therefore to set aside $450 out of the gross indicated profits. This will be done by making a debit entry in profit and loss after gross profit has been ascertained while a corresponding credit is entered in a new ledger account called "Reserve Fund" or "Surplus." This sum may be disposed of in any way that the concern decides to be desirable. If it now follows the same policy as before and invests in bonds, it of course draws on cash to that extent, thus crediting cash. A bond account will be opened and will be debited for the amount spent for the bonds. The reserve and bond accounts are now open and the credit entry in the one is the same as the debit entry in the other. The reserve is practically a part of capital account, it being a sum retained in the business while the bond account with its debit entry merely means that capital assets have been invested to that extent in bonds. If at some time in the future it is ascertained what depreciation has occurred, the assets are written down to that extent and a corresponding debit entry is made in reserve, reducing it by a similar amount. The concern has the bonds among its assets and they will

appear as such. If, however, it is desired to restore the assets to their original condition by drawing on the reserve, the bonds will be sold in whole or in part and bond account will be credited correspondingly. The cash thus realized will of course be debited to cash and when spent in repairing or replacing the assets cash wi" be credited and a corresponding debit entry in the assets account will be made. Meanwhile, if the fixed assets have not been revalued, or, what is the same thing, if depreciation has not occurred, they appear at their original value and the amount carried to reserve fund is simply a net addition to the funds invested in the business. If, however, it has been determined simply to use the cash on hand and retained in the business as a reserve or as offsetting depreciation, in the same way that any other cash would be used, the concern will reduce its valuation of the fixed assets and will use a corresponding amount of cash in buying more floating assets. Here there is a gradual transfer of fixed assets into floating, the reduction in the value of the fixed assets being represented by the process of writing off, while the regular accounts with the floating assets are increased to correspond to outlays of cash made for the purchase of further items of property for use in doing business. The concern knows that it is putting back into the business as much as it is losing from the business in the shape of wasted assets, and it is satisfied with the fact that the business has in all of its branches the same amount of value that it originally had, even though this value is now differently distributed.*

Choice of Methods.

A choice between these different methods of accounting for depreciation cannot be arbitrarily indicated but

*What has been said of the treatment of depreciation may be summarized by quoting from Mr. Cole (Accounts, page 89) with reference to the way in which depreciation may appear on the balance sheet (Cf. our own section on balance sheets, pp. 161, ff., of the present volume). Mr. Cole remarks: "Depreciation fund may appear on the balance sheet in one of three combinations: (1) among assets only-in which case specific property is set aside to

must depend somewhat on the kind of business in which the problem presents itself and the policy which it is desired to follow in connection with the business. Theoretically, the simplest way of dealing with the matter is that of setting aside a given sum as an allowance for depreciation, the nominal assets being reduced by a corresponding amount and all payments for new assets being made out of this fund. Practically, the ordinary business will usually not follow this plan but will adopt the system of annually putting into various forms of machinery or plant, about the amount that it is considered the assets have run down each year. This gives rise to continued debit entries either in the various plant and machinery accounts or in a betterments and improvements account, and to corresponding credit entries in cash account which pays for them. If the old assets are reduced in value by revaluation, such revaluation being exhibited through credit entries representing the wastage, these credit entries will be paralleled by debit entries in the corresponding machinery or assets accounts. If the wastage is less than the reinvestment, the surplus will show on balance sheet as an increase or, if more, as a reduction of assets. The cost of the betterments goes to profit and loss as an expense. The important matter from an accounting standpoint is that the value of the capital in the business shall be maintained and so represented. Changes in the value of particular assets representing the capital are of secondary importance.

It will be necessary to deal further with this matter of depreciation when we come to speak of the question of balance sheets. From what has been said it is clear that the goods account involves a set of entirely new and replace or repair machinery, or buildings, or whatnot, that are thought to have suffered actual depreciation; (2) among both assets and liabilities-in which case specific property is set aside from net income as a safety fund for possible depreciation not thought to be actual; (3) among liabilities onlyin which case the amount is deducted from net income and shown on the books as a safety fund for replacement purposes, but the actual property is left among the general assets without specific designation. In the first case, the fund could not be distributed to stockholders without impairing capital; in the other two cases, the policy might be changed and the fund distributed."

important problems as soon as the "goods" bought by the concern are of a fixed character which may depreciate or increase in value.

Causes of Deterioration.

It is worth while in this connection to consider just what causes give rise to loss of value and may therefore be studied by the business concern which desires to make up its mind regarding the probability of depreciation as a factor in its doings and to reach a decision as to the degree of necessity for a distinct and specific provision against loss. Neglect of them has sometimes thrown a business into an embarrassed position because of failure to provide for a contingency which was considered remote and for which therefore no distinct provision was made. The main causes of deterioration are as follows: (1) The consumption of items of capital during a period of production. An example of this sort is seen in the case of tools which are worn out in manufacturing processes. (2) The reduction of the value of privileges and rights. An example of this sort is seen in the case of a patent which runs for a definite period and whose value is therefore reduced each year as the length of its life grows shorter. A lease paid for in a lump sum at the beginning is another illustration of the same kind. (3) "Wear and tear." This is simply the natural reduction in efficiency or durability which objects of material character undergo as a result of use. (4) General exhaustion of efficiency as seen in the decreasing usefulness of an object in connection with the service for which it was intended notwithstanding it shows no perceptible wearing out. Certain electrical apparatus illustrates this obsolescence. this obsolescence. (5) Improvements tending to reduce the value of given capital or machinery. This is seen in cases where a given sum has been invested in a material object, say type for printing which is then rendered obsolete by the appearance of some mechanical device that supersedes it, as, for instance, the

typesetting machine, which dispenses with the use of movable types and substitutes type directly cast in a mold in the machine. (6) Reduction in labor or material costs where contract has already been made for a given amount of labor or material at a price which holds the concern to the use of a more expensive method of production. It should be noted, however, that business losses directly and unmistakably due to mistaken policy or bad judgment cannot properly be charged as "depreciation." Depreciation relates to assets as such, whether they be tangible or intangible. Provision against business losses as such is properly called "contingent reserve" and is part of surplus.

But in whatever way deterioration may occur, it constitutes a final source of business loss and in most cases cannot be definitely counted on in advance. The object of allowing for depreciation is thus not merely one of accounting, but is also one of business policy. The business firm which does not make any allowance for depreciation is putting itself in a hazardous position from which it may have great difficulty in emerging, owing to the sudden occurrence of depreciation which makes it necessary for it to change the machinery already installed or to incur other expense without having made any allowance in advance for resources with which to carry out an expensive undertaking of this description. In such a case the concern is obliged either to borrow funds, thereby creating an additional capital liability, or else to recognize a reduction in the nominal value of its capital, thereby recapitalizing on a lower basis, or else to get the funds out of money that would otherwise have gone for dividends, thereby suspending its dividends or reducing them.

Estimating Depreciation.

In the illustrative cases already given, it has been assumed that depreciation could be more or less accurately estimated. Thus we suppose that Smith & Brown had no trouble in engaging an expert to go through their es

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