Digitiz-ed by the Internet Archive in 2007 with funding from IVIicrosoft Corporation http://www.archive.org/details/depreciationcharOOcartrich DEPRECIATION CHARGES OF RAILROADS AND PUBLIC UTILITIES A MEMORANDUM FILED WITH THE DEPRECIATION SECTION OF THE BUREAU OF ACCOUNTS OF THE INTERSTATE COM- MERCE COMMISSION By ROBERT A. CARTER, Chairman of the Committee on Rate Fundamentals of the American Gas Association; and WILLIAM L. RANSOM, of the New York Bar. A. W. Stevens, Printer, 300 Wash'n St., Bklyn., N. Y. — Main 2300. IXDEX PAGE Reasons for Interest in Subject 1 Effect of Increased Eailroad Rates on Costs of Utility Service in New York City 2-5 Pertinent Provisions of the Interstate Commerce Act 5-7 Purposes of the Statute Analyzed 7.-9 Nature of *' Depreciation Charges^' as to Railway Property 9-14 The Sound Treatment of ** Retirement Expense'' 14-18 xlnalysis of the ** Depreciation Charges'' of Railway Carriers Since 1912 18-23 Concrete Recommendations as to the Handling of ** Depreciation Charges" 23-24 The Two Opposing Views as to Provisions for the Upkeep of Property 24-26 Decisions of the Courts and Regulatory Commissions Concerning These Op- posing Views 26 The New York S Queens Gas Co, Case 26-32 Consolidated Gas Co. vs. Newton (267 Fed. 231) 32-36 N The Nashville, C. 'S St. L. By. Co. Case 36-43 ^50473 II PAGE Basis of the 1920 Grant of Increased Freight Eates 43-45 The Knoxville Water Co. Case 45-46,48-57 The Minnesota Rate Case 46-48 The Kansas City Southern Ry. Co. Case.. 56-58, 92-93 The First Consolidated Gas Co. Rate Case 58-63 California and Oklahoma Decisions Cited as Adverse Authority 70-73 Essential Purposes of the Statute and the Relation of ^^Depreciation Charges'' Thereto .....< 73-74 Reasons Why the Cost of Retirements Should Not Be Anticipated Through Accruals Based on **Life Tables''. . . 74-76 Concrete Illustration of the Reasons Why the Rate Should Not Be Burdened With Charges Anticipating Future Retirements 76-80 Other Decisions of Courts and Commis- sions 92-101 Summary of Conclusions From the Fore- going Decisions 101-102 Basic Objections to the ^^ Accrued Depre- ; ciation" Theory 102-105 The Brooklyn Borough Gas Co. Case and Other Recent New York Rulings 105-107 In Conclusion 107-108 nao EAST :fifxeent-H sijreet -New York City. vChief vof -the Depreciatiotn Section, bureau of AccouiLts, Interstate Commerce CommissioJi^ WasJainglan, D, CL Tkm imemorandnm, m letter form, is submitted Iby way of compliance with your courteous com- imimication ;o tial to the convenience, comfort, health and life of the inhabitants of the City of New York and adjacent territory served by these companies, and to the continuance and prosperity of the business enterprises carried on therein. We desire greatly, in the first place, to furnish an efficient and acceptable service to all our con- sumers and patrons, and, in the second place, to charge them a rate no higher than is absolutely necessary to reimburse us for operating expendi- tures actually made, and yield, in addition, a fair return on our actual investment as judicially es- tablished. We adhere to that standard in the fixa- tion of the rates charged by our companies; we desire that railroads and regulated utilities whose service we require in the carrying on of our busi- ness, shall do the same thing. The amount of money which we have to pay out for freight rates becomes a large item in our operating costs ; and we, in turn, as patrons of railway service, do not wish to pay excessive rates or rates inflated by fictitious charges, in the guise of operating ex- penses or anything else. In the production of these great quantities of gas and electric energy and, to a lesser extent, in transmitting the same from the manufacturing and generating plants to the premises of myriad consumers, there is required the consumption and use of vast quantities of coal, oil and other mate- rials, all of which coal, and a large part of which other materials are necessarily transported for greater or lesser distances over the lines of rail- road common carriers operating in interstate com- merce within the boundaries of the United States, for which transportation the Consolidated Gas Company and its affiliated gas and electric com- panies pay annually large and increasing sums of money in freight charges, the total of such charges paid by them and charged to their operating ex- penses amounting, on coal alone, during the year 1919, to not less than $3,967,422.00, and to a sub- stantially greater sum in 1920. During the calen- dar year 1919 there were delivered by rail trans- 4*. jrortatibn 798,937' gross tons of coal! to^ tliese' affili^ atedi gas companies- and. 1,008^312. gross tons to> tihe affiliated, electric companies, a total of. more* than; 1,800,000. tons of coal, all of which, wasi usedl in the generation: and. distribution of gas andi elec- tricity during 19I9.\ The quantity usedi im 1920) amounted.to.more than; 2,200,000 tons. By reasoni of the foregoing, the gas andl electric industry conducted. by the Consolidated! Gas. Company and' its affiliated! companies- has been: and! is- one of the largest, patrons of rmlroad! transportation ini the United; Stiates;. In the const!ruction"of new. plant; the installation; of additions: to. apparatus and! equipment, the re- pair and! upkeep of. structures and! apparatus, the', making of replacements and extiensions of. the dis- ttributing systiBms,- andithe Hke, there is required! the use of. large quantities of brick, cement; steel,, brass-work, iron' pipe,' and! other matierials, uponi which, the freight charges amount, to- many thou- sands of. dollars annually, which, freight: charges; add greatly to the annual. cost of the maintenance,, repair and. upkeep of the properties of. these affib- ated. companies' in; their, continued; high, state of operating efficiency, and . add . substantially to ; the • Gost. off the. new construction, which, ini turn, be- comesa part of the necessary investment: of the' companies in property required : for the carrying on of the gas; and! electric business, upon . which i the consumers must pay a rate yielding ;a . fair re- turn ' from year, to year; . By reason' of the effect' on both' our operating expenses and! our required' investment, we feel' that we are directly and' actually interested in seeing to it that the burden of the charges of rail- road common carriers for the transportation of ' ooal, oil, brick, cement, iron, steel, pipe and other- materials in i interstate commerce, shall! be and be.' 5 kept nt) greater than is from time to time reasdii- ably necessary to pay tlie actual cost of the rend- ering of adequate and efficient service by such common carriers and the maintenance arid upkeep' fof their property in first class o-perating condition,, and to^ pay a reasonable return upon their in- vested capital. That interest leads' to the prepa-- ifation and filing of tliis' memorandum.- The Pfertinent Provision^ oi thi6 Statute^ Turning tO' the particular" statutory dnty of the' Interstate Commerce Commission und^r discus-- sion, it may be n^ted- that S'eeti<^n 15a> paragraph- ^ of the' Interstate Commerce Act, as' amended, re- quires that the rates of" carriers by railroad be so' adgustedi that the saidi carriers u# * * ^Qii^ under honest, efficient and' eco- nomical- management and reasonable expendi-- tures for maintenance of way, structures and equipment, earn an aggregate annual- net rail- way operating income eqnal as nearly as may' be to a fair return upon the aggregate value' of the railway property of such carriers held- for and. used- in the service" of frarifeporta-- tion.''' smd' Paragraph 3^ of the same section provides- * * that during the two* years beginning jtfarcli' 1, 1920, the Cbmmigsionshall'take as siich fair return a sum equal' to^ 5i^ per ceriturii of such' aggregate value, but may, in its discretion, add' thereto* a sum' not exceeding oriie-half of one per centum' of such aggregate value to' make^ provision in" whole or in part for im- provements, betterments or equipment, which, according to the accounting system pre- scribed by the Commission, are chargeable to ' capital: account ' ' '; ; while Paragraph 1 of the same section defines the term *^net railway operating income" as ** railway operating income, including in the computation thereof debits and credits aris- ing from equipment rents and joint facility rents." The term ** railway operating income" has seemed to us to be used in the statute in obviously the same sense as in the accounting system pre- scribed by the Commission; namely, to denote any excess of railway operating revenues over railway operating expenses. Section 20, paragraph 5, of the Interstate Com- merce Act directs that **The Commission shall, as soon as prac- ticable, prescribe, for carriers subject to this Act, the classes of property for which de- J: preciation charges may properly be included under operating expenses, and the percent- ages of depreciation which shall be charged with respect to each of such classes of prop- erty, classifying the carriers as it may deem proper for this purpose. The Commission may, when it deems necessary, modify the classes and percentages so prescribed. The carriers subject to this Act shall not charge to operating expenses any depreciation charges on classes of property other than those prescribed by the Commission, or charge with respect to any class of property a percentage other than that prescribed therefor by the Y Commission. No such carrier shall in any case include in any form under its operating or other expenses any depreciation or other charge or expenditure included elsewhere as a depreciation charge or otherwise under its operating or other expenses.' ' Purposes of the Statute Analyzed The purpose of the prohibition contained in the sentence last quoted above has seemed to us to be obviously the prevention of excessive or im- proper charges to expense accounts through du- plicated charges, and the purpose of the provi- sions respecting the so-called ^* depreciation charges" is to keep them within reasonable bounds. The necessity for strict scrutiny and reg- ulation by the Commission in this regard appears clearly when it is considered that the net rail- way operating income, which the statute directs shall be kept large enougl^ to yield for the car- riers of a rate district a fair annual return on the aggregate value of the property devoted to rail- way service} is in turn dependent on the railway>^ operating income, which is what is left after de- ducting railway operating expenses from railway operating revenues>)L In order that the schedules of railway rates at a given time in force may not wrongly be made to appear to yield an insufficient net operating income, and so, because of inflation of the operating expense account, appear to be inadequate, the Commission has now specifically been given the duty, as well as the power and jurisdiction, to control the estimated charges for ^^ depreciation'^ and the basis thereof. The im- '^ portance of this we shall hereinafter discuss with concrete references to the so-called * depreciation reserves'' of the carriers.^AVithout the possession *^ and exercise of this power by the Commission, any carrier would be left in position to include in its operating expenses unnecessary and excessive charges under this head and thus make its reven- ues and rates appear inadequate upon the face thereof w^hen in fact they were ample or more than amplej^ Another consideration impelling the "^ Congress to confer and the Commission to exer- s cise this power of regulation of ctorges bas^ed on estimates is no doubt to be found in paragraph 6 of Section 15a of the mm& statute, which requires that * ^*If under the provisions of this section, any carrier receives for any year a net railway operating inconxe in excess of 6 per centum of the value of the railway property held for and used by it in the service of transportation, one-half of such excess shall be placed in a reserve fund established and maintained by • such earlier, and the remaining one-half thereof shall, within the first four months fol- lowing the close of the period for which such computation is made, be recoverable by and paid to the Commission for the purpose of es- tablishing and maintaining a general railroad contingent fund * * *'^ and to the further effect shown in the statute. If the carrier had been or were left subject to no con- trol in respect of the charges which it might make to operating expenses for * ^ depreciation ' ^ it might easily, if such charges were based on estimates and were not kept in close relationship to the ac- tual disbursements, make these estimated charges sufficiently high to create the appearance that its ^*net railway operating income" for any year did not reach ^ * six per centum of the value of the rail- way property held for and used by it in the service of transportation'' and thus deprive the *^ general railroad contingent fund'' of moneys that should go into it in accordance with the provisions and in- tent of the statute. % Nature of "Depreciation Charges" as to Railway Property In order to determine what amounts may prop- erly be charged to operating expenses to repre- sent * depreciation '^ as defined in the Act, and the manner in which, as a practical business matter, this phase of railway operation and management should be handled, it is necessary to bear in mind the proper purpose of such charges. The word ** depreciation,'' as commonly used, has a variety of meanings. V. One of the most prevalent is to de- note a decline or shrinkage in exchange value or market pricey That, however, is obviously not the meaning intended by Congress to be attached to the word as it is used in the Interstate Commerce Act. Changes in value are matters of fact to be determined by observation and not by rule pre- scribed by the Commission. The accounts of a "^ carrier must deal with receipts and outlays — facts, not opinions as to variations in value or as to the probable lapse of time before particular units of property will be retired from use. The railway property of a carrier is held for use and not for sale; and fluctuations in its value, if and as they occur, do not have any relation to the car- rier 's operating expenses. A merchant may prop-'' erly reserve out of his revenues sums to provide against shrinkage in the value of goods remain- ing unsold, below their cost, for, until the complete stock of goods is sold and converted into money, the real profit or loss from his venture cannot be ascertained. The rolling stock, road-bed and '^ equipment of a carrier by railway are not acquired for sale like merchandise ; they are expected to be operated forever in furnishing transportation, or at least for an indefinitely long period. >The car- rier sells transportation service to its patrons, not its railway 'property piecemeal. A railway system "^ 10 is composed almost entirely of tangible property that could not readily, and to a large extent conld •^not economically, be converted to other uses. Its ownership may change and the price at which the transfer is effected may be greater or less than the cost of the property when installed, but it does not appear that the utility of the property or its relations to the shippers and passengers using it •^is thereby affected. The rate charged for the transportation service does not depend upon the age of the engine, road-bed, or car; nor can it properly be said that the carrier's operating ex- penses vary with changes in the exchange value of the property or the cost of reproducing it at a particular time. As has been said by Mr. George N. Webster in a recent monograph* on the sub- ject : ' **The consideration of age enters no more into the question of the rates of a public serv- ice company, which is able to and does ren- der the service it was organized to render, than does the age of a taxicah^ or of its driver, or of the clothes he ivears, enter into the question of the fare. A driver twenty years old with a new car and a new uniform can charge no more than a man of sixty with a ten-year-old car still operating efficiently. It is transportation the passenger is buying — and he expects to pay uniformly for a uniform service, regardless of the age of the equip- ment. ^*Nor does a lawyer or a physician expect to regulate his fee by the age of his office furniture, as one might think he should from the arguments of the professional depreci- *Copies of Mr. Webster's monograph entitled "Theoreti- cal Depreciation: A Menace to the Public and the Inves- tor," have been reprinted, and will be furnished to anyone interested, on request to the undersigned. 11 ator. A laborer of twenty with a new pair of overalls draws the same rate per diem as the laborer of sixty with a pair of wornont overalls. Both do a uniform day's work for a miiform day's pay and age cuts no figure so long as uniformity in service capacity exists. **A celebrated lawyer who died within a year and who bequeathed many millions of dollars to a great college had in his office the simplest and oldest furniture the writer ever saw. Furthermore, his earning capacity in- creased annually to the day of his death at the age of seventy-four. He probably never realized w^hat a liar he was making out of the professional depredationist. '' y So far as the passenger and the shipper, the purchasers of raihuay service, are concerned, the essential thing is that the system be main- tained in efficient operating condition and that its service be rendered efficiently, economical- ly, and at a fair price. Its operating expenses are the out-goes necessary to efficient and eco- >^omical operation. It has been commonly rec- ognized that in the case of a railway or other public utility, the cost of the maintenance of the property in efficient and economical operating condition, through adequate repairs of wearing parts and through the renewal and replacement of units retired from use for any cause, is a proper charge against the cost of rendering the service as represented by operating expenses; and the statute has declared that the fair price for the service rendered shall be so determined, as nearly as may be, as to yield, in addition to such neces- sary outgoes, a further sum which shall be, for the carriers as a whole, in a given rate district, **a fair return upon the aggregate value of the rail- 12 way property of such carriers held for and used in the service of transportation." The statute does not contemplate the inclusion of anything beyond this in fixing the rate. It is a matter of common knowledge that in any extensive or complicated system, plant or instru- mentality, such as that of a railway or public utility, the thing does not wear out or give way as a whole. Some part wears or weakens to the point that it ceases to operate satisfactorily, and upon being repaired or replaced, the whole con- tinues to operate satisfactorily. These repairs and replacements in respect of any particular unit of plant or equipment become necessary only at irregular intervals, but in an extensive and hetero- geneous railway or utility system subjected to a variety of hazards, they tend to equalize them- selves from year to year, and the tendency is still more marked if longer periods be compared. The statute does not indicate how frequently the Commission shall revise and adjust the gen- eral level of rates for the carriers of a particular rate district, but presumably such readjustments will be made only at intervals of several years. It takes an appreciable period of time for traffic to adjust itself to a new level of rates and such level ought not to be disturbed until it becomes clear that it is inadequate or excessive. If the intervals between readjustments of rate levels are long enough to permit the law of averages to operate with respect to repairs and renewals and replacements of rolling stock and equipment, it seems apparent that there would be no occasion at all for the introduction of any estimated charges 'into operating expenses, to secure a fair statement of cost of operation for the period. If the intervals are too short for this, the justifica- tion arises for the admission of charges based on 13 estimates of current outlays. Such estimates, however, when permissible, should be restricted to elements other than anticipated shrinkage in ** value" of parts of the property, for, as has been said above, the carrier is not a trader or merchandiser in respect of its railway property and its duty in connection with its property is to maintain the same in efficient operating condition and to operate it efficiently and economically in the transportation of goods and persons ; and any charges for repairs, renewals and replacements, w^hether actual or estimated, should be based only upon the actual requirements for those purposes. When any part of a unit of railway property wears to such a point that the particular unit no longer operates efficiently, it is the carrier's duty, under the statute and in the exercise of ordi- nary business judgment alike, to either repair it or replace the w^earing part of such unit, and thereby to overcome the actual deterioration of the unit and restore it to full operating efficiency. *^If in the interval since a complete unit was in- stalled, the art of transportation has progressed to such a point that it has become obsolete or is inadequate and the economies to be realized justify its withdrawal from service, it should be replaced with a unit of improved type and ade- quate capacity, and the cost of retiring the obso- lete or inadequate unit, if too great to charge against the provision for renewals for the cur- rent year, should be borne by future passengers and shippers. ''Abandonments occasioned by changes of this character are therefore charge- able to future earnings.^' (Kansas City Southern ^Ry. Co. vs. U. S., 231 U. S., 423, 451, 452.) 14 The Sound Treatment of "Retirement Expense" When a given unit of property used in transpor- tation service is installed, the executives who financed its installation and are charged with the duty of maintaining the property as a whole and with making financial provision therefor, realize that certain things may transpire as to the new unit of property or portions thereof. If it is of such a character that it has wearing parts, or that portions of it will be affected by the action of the elements, the executives of course are aware that repairs of such wearing parts will have to be made from time to time, else the unit and property as a whole will not function efficiently and will break down altogether if these repairs are not made as required. On the other hand, they are aware that a large portion of the property, at least if properly maintained by these repairs and renewals of wear- ing parts, has a practically indefinite life in ser- vice, unless its retirement from use comes about from causes in no way related to the effects of use. At a recent hearing before the Federal Power Commission, the Secretary of War, Mr. Weeks, trenchantly inquired of a distinguished hydraulic engineer whether an estimate could soundly be made as to the probable **life'' of a dam such as would figure in a water-power proj- ect. The reply was, in substance, that such a thing could hardly be calculated, because dams known to be more than 2,000 years old are still functioning and in use, with no signs of going out of service because of any consequences of age, use or wear. Probably these dams, too, have had practically no repair work done upon them since they were built before the Christian era. As has been said by Mr. Webster in the mono- graph already referred to: 15 ** Stephenson's second locomotive was still in use in 1911 (E^icjineering and Contracting, October 11, 1911). The cast-iron water- pipes leading from the river Seine to the foun- tains at Versailles, were installed in 1658, The only repairs that have been necessary after two and a half centuries of service are the occasional replacing of bolts (Engineer- ing and Contracting y May 27, 1914). Kome is still supplied with water by an aqueduct, the construction of which was begun by Quin- tus Marcius in 144 B. C. Tunis is now sup- plied by an aqueduct built by Hadrian in A. D. 120. The aqueduct at Nimes has been in use for nearly twenty centuries. There are many other instances of masonry and concrete structures which have survived many hundreds of years of useful service.'^ The wearing parts of units of railway property are currently repaired as needed, and the effect is to maintain the unit in existence and in high operating efficiency, for an indefinite and unde- finable period, and the expense of this repair and replacement of wearing parts is properly assessed by the comj^any executives against the current cost of rendering the service in which the use and w^ear took place. The responsible executives of the carrier also realize that although the newly installed unit may continue in use for an indefinite and incalculable period, if thus maintained in good operating con- dition, it may go out of use, for other causes than wear or the flight of time, and that such retire- ment from use may come about at almost any time — a time in no way susceptible of estimate at the time it is installed, but varying altogether with the particular carrier, the particular territory be- ing served, the nature of the service being ren- 16 dered, the various factors affecting the cost of ser- vice, and the like. The unit may be retired from use because it has become inadequate to meet the growing demands for service (and hence is uneco- nomical) or because new inventions have resulted in improvements in the type of a given unit, mak- ing its retirement economical in the interests of future patrons. A larger volume of traffic can be handled or the existing volume of traffic can be handled more cheaply or more efficiently, if the present unit is removed and a new one put in, al- though the unit taken out is still functioning as efficiently as when installed. The time when such supersession of a unit will take place cannot be forecast in terms of years, by company executives, engineers, or any one else, at the time the unit is installed. ** Tables of useful lives'' of units of that kind are unavoidably conjectural and speculative, bearing no possible relationship to the controlling factors, which vary utterly with the individual instance. To try to ** assign'' a probable period of *^life" to the unit when it is installed, and then charge against current rates an accrual based on the amortization of the cost of the unit over that period, is to set up a system of swelling operating expenses and ** padding" rates on a basis of mere conjectures, because with the great mass of raihvay property its proper maintenance by current repairs con- signs all ^^life tables" to the realm of silly im- practicabilities, and supersession, when it does take place, occurs for causes in no way related to such **life tables." Moreover, such super- session comes about for causes which make im- proper the amortization of its cost through in- creased rates during the period before it is super- seded.yr^^ ^^it did not wear out in the service of the patrons it served. They paid the cost of maintaining it in good, undiminished operating 17 efficiency; there is no reason why they should, in addition, pay the cost of retiring it to put in a new unit which will serve more patrons or serve future patrons more cheaply \i^^]\Q existing unit was serving present patrons e&ciently; the cost of retiring it to put in a larger or more economi- cal unit becomes a proper charge against those who will be served and benefited thereby.)/ The ex- '^ pense of retiring property should therefore be borne hy current or future charges, and not by anticipatory accruals (Kansas City Southern R^. Co. vs. U. S., 231 V. S., 423, 451-2)yin other words, the retiring of a very large unit may necessitate the distribution of the amortization of the invest- ment therein, over a short period of succeeding i^ years. >^ It thus appears that wherever departure is made from the actual current outlays, year by year, for repairs and for the renewal and re- placement of property withdrawn from service, ** depreciation '^ charges in operating expenses should in any event be restricted to those neces- sary to equalize from year to year the charges for extraordinary repairs and for renewals and re- placements which occur irregularly. As experi- ence shows that in large plants and other utilities whose property is distributed sufficiently widely to be subjected to a variety of hazard, the actual costs of repairs and retirements tend to equalize themselves when taken over a period of years, it is apparent that there is no need at all for per- mitting the introduction of estimated charges in operating expenses to cover the matter of ** depre- ciation'' in connection with the determination of a fair level of rates as defined in the statute, unless the Commission contemplates frequent readjust- ments of the rate level. If such frequent read- justments are contemplated, the regulation of such 18 charges should be based on the actual present and past experience of the carriers, and the charges themselves should be proportioned on the basis of the work done rather than on mere lapse of time. Extensive reconstruction projects involv- ing numerous renewals and replacements cannot advisably be undertaken at a time of the year when the plant is working under full load or over- load, for at such times operation would be too much impeded by the execution of any mainte- nance work in excess of actual immediate needs. Furthermore, at such times prices are usually high and the supply of materials and labor re- stricted, and it would be uneconomical to do work of this character which is not absolutely essential to the continuity of operation. In such periods, therefore, when the actual disbursement for main- tenance work is comparatively small, the esti- mated charges may properly, if ever, be intro- duced in operating expenses to make provision for the time when traffic has slackened and the forces of the carrier can advantageously be concentrated on maintenance work. Analysis of the "Depreciation Charges" of Railway Carriers Since 1912 Illustration of the pertinency of the foregoing suggestiontthat care be taken to limit ** deprecia- tion charges ' ' to actual maintenance requirements rather than to base them on tables of assumed *4ives" of property ^is afforded by the fact that an examination of the figures published in the In- terstate Commerce Commission's reports on rail- way statistics shows that during the four years from June 30, 1912, to June 30, 1916, the credit balance in the reserve account ^* Accrued depre- ciation" for all Class I railways and their non- 19 operating subsidiaries increased from about $300,- 000,000.00 to about $555,000,000.00. In other words, the charges to operating expenses for ^^ de- preciation'^ during those four years were $255,- 000,000.00 greater than was necessary to provide for all retirements of equipment and other rail- way property made during that period and charged against the reserve thus created. How- ever, owing to some anomalies in the Commis- sion's rules of accounting at that time in force, there were charges made to *^ Profit and Loss'' account to the extent of about $59,000,000.00 for **loss on retired road and equipment." Granting, for the sake of argument, that all of this $59,- 000,000.00 might properly, in the absence of the ** depreciation" charges in operating expenses, have been made to operating expenses, it is still true that the charges to operating expenses in this connection ivere about $196,000,000.00 (the differ- ence hetiveen $255,000,000.00 and $59,000,000.00) greater than were necessary to provide for all re- tirements actually made during those four years, or, in other ivords, for all renewals and replace- inents necessitated during that period on the as- sumption that such renewals and replacements had cost no more than did the things renewed or replaced. The Commission's rules properly per- mit the excess cost of the replacement over the cost of the original to be charged to the road and equipment account, so that it is shown by the Commission's figures that the operating expenses of Class I carriers and their subsidiaries were overstated during those four years by nearly $200,000,000.00. Similarly, for the eighteen months from June 30, 1916, to December 31, 1917, the credit balance in the reserve account ** Ac- crued depreciation" for such carriers increased about $224,000,000.00, whereas the charges to ** Profit and Loss" for **loss on retired road and 20 equipment/' during the twenty-four mont*hs from December 31, 1915, to December 31, 1917, were about $30,000,000.00. Owing to the change in the reporting year from that ending June 30th to that ending December 31st, there is an overlap of six months in the income accounts and profit and loss accounts contained in the annual reports relating to the year ended June 30, 1916, and that ended December 31, 1916, and it is impracticable to say, from the figures published by the Commission, what this item of **loss on retired road and equipment'' charged to *' Profit and Loss" is for the eighteen months from June 30, 1916, to December 31, 1917. It is safe to say, however, that it is materially less than thirty millions of dollars, and therefore that the mnounts cliarged to operating expenses for ^' depreciation' ' during those eighteen months were more than $194,000,000.00 in excess of the amount of retirements actually made during that period, so that for the five and one-half years from June SO, 1912, to December 31, 1917, the amounts charged for ^' depreciation' ' in operating expenses ivere over $390,000,000.00 more than ivas necessary to provide for all of the retirements ac- tually made during the period; or, in other words, the operating expenses of this class of railroad common carriers as reported during that period were, so far as this item is concerned, overstated by at least $390,000,000.00, with corresponding ef- fect upon the net operating income and so upon the apparent adequacy or inadequacy of the rates paid by the companies represented by the under- signed, in common with all other users of similar commodities, for the transportation of coal, oil, iron, steel, pipe and other materials in inter- state commerce. Another concrete instance emphasizing the im- portance of sound treatment of ** retirement ex- 21 pense'' may be taken from the records of a reg- ulated utility of whose service the Consolidated Gas ComjDany (with its affiliated companies) is probably the largest single patron. The sums which we have to pay for telephone service enter heavily into our operating expenses, amounting to more than $200,000 per year. Examination of the figures published by the Public Service Commis- sion for the Second District shows that as of De- cember 31, 1914, the credit balance in the two re- serve accounts of the New York Telephone Com- pany, entitled ^^ Accrued Depreciation'^ and '' Amortization, '^ was $25,498,912. Five years later, after taking care of all retirements of fixed capital actually made over this considerable pe- riod, the accruals had increased the reserves to $63,390,038. In other w^ords, the rates charged during the five years had included the collection by the company, from us and other consumers, of $37,891,126 more than the actual cost of prop- erty retirements during the same period. In the same five years, the telephone company's invest- ment in fixed capital devoted to its telephone busi- ness was increased $76,805,076 by the addition of new facilities and equipment. Thus while less than $77,000,000 of new property was being in- stalled, 49.33 per cent, of its total cost was being collected from consumers, over and above the ac- tual requirements for the five years, on the theory of providing for possible but uncertain future re- tirements. During the eight months ended August 31, 1920, the credit balance in these reserves was increased $6,580,064 over actual retirement ex- penses, whereas only $14,460,695 w^as in the same period added to the company's capital investment. In other words, over a period covering five years and eight months, the company collected from its consumers, to make good its losses from the retirement of property from service, $44,471,190 22 more than its actual losses from such retirements over this considerable period, or approximately $7,850,000 in excess of average actual yearly re- quirements ; and the credit balance in its reserves, as of August 31, 1920, representing collections from consumers over actual retirements, was $69,- 970,102, or nearly 35 per cent, of its aggregate property investment of $240,432,094. Whether the rates charged by the telephone company or by the railway carriers are or were reasonable or excessive, we do not undertake to say. That question is for the regulatory commis- sions charged with the duty of seeing to it that such rates are kept neither too high nor too low. Our comments are only upon a system of accruals through charges to operating expenses on the ba- sis of theoretical estimates, which leads to the col- lection of sums so greatly in excess of the actual retirement expense over a representative period. Whether the rates actually charged yielded more than a fair return over and above actual operating expenses, we do not here discusSy Any sums collected in excess of actual operating costs, including the actual retirement expenses (aver- aged, if desired, over a representative period) should be collected as return on investment or not at all. No carrier or utility should be permitted to collect from its patrons more than its operating expenses plus a fair return, and no carrier or util- ity should be permitted to make its return from existing rates appear inadequate through charg- ing to operating expenses a sum whose accrual is not required by any actual outlays of the com- pany, either current or prospective/^ No implica- tion is intended to be conveyed agamst the policy of making reserves, out of the fair return, for contingencies, if it is deemed advisable to thus se- gregate a part of the surplus earnings. There 23 should be left, however, no room for doubt that when thus segregated such a reserve still repre- sents surplus earnings belonging to the stockhold- ers and that upon the property in which it is in- vested the company has as unquestionable a right to earn a fair return as it has upon the property representing its surplus so called. Concrete Recommendations as to the Handling of Depreciation Charges These were the practical considerations which led the Consolidated Gas Company of New York, in its petition of June 1, 1920, as intervenor in Ex Parte 74 before the Commission, relative to in- creases in freight rates, to present to the Commis> sion a more formal statement of the foregoing con- tentions, and accordingly to urge upon the Com- mission the following suggestions, which are of equal pertinency to your present inquiry : * * 1. That the above-stated considerations be taken into account and kept in mind by the Commission in all pending and future pro- ceedings for the fixation of the rates charge- able by railroad common carriers in inter- state commerce. **2. That the petitioner be permitted to in- tervene and be heard, by counsel, in such pro- ceedings, and to file a brief therein, in behalf of the considerations hereinbefore stated. **3. That the Commission will find that for Class I carriers there are no * classes of prop- erty for which depreciation charges may properly be included under operating ex- penses,' and that it will require that the main- tenance charges for any calendar year, in- cluding charges for renewals and replace- ments, he stated on the basis of expenses ac- 24 tually incurred during that year, to the end that freight rates be placed at a level which will be fair both to carriers and to shippers, and that they be not made unduly high in or- der to provide for estimated charges not based on actual facts. **4. In the event that the Commission be of opinion that a year is not a suthciently long period to include representative fluctuations in maintenance charges, the petitioner prays that the rules governing estimated charges for 'depreciation^ shall hereafter he based on the actual experience of the carriers during a period of a length reasonably sufficient to in- clude such fluctuations and that the estimated charge shall he distrihuted from year to year upoh a suitahle operating unit (such as, for example, car-miles), so that during years of heavy traffic the estimated charge may be cor- respondingly great and during years of light traffic it may be correspondingly less, and thus avoid, so far as may be, fictitious fluc- tuations in the ' net railway operating income ' which the statute makes the test of the ade- quacy or inadequacy of a given schedule or level of rates." The Two Opposing Views as to Provisions for the Upkeep of Property In line with the foregoing, there may be said to be two opposite views, two radically differing pol- icies, which may be followed by a regulatory body in fulfilling duties such as those devolved upon the Interstate Commerce Commission by Section 20 of the Interstate Commerce Act as amended : / 25 1. The course four-square with business practice in large utility and industrial estah- lishments; which recognizes that property- used in public service does not go out of use on arbitrary or theoretical grounds or accord- ing to any preconceived ** table of lives," but for reasons not calculable in advance as to time, and commonly related to economies in the cost of service or increases in demand for service ; and hence does not make ' ' accruals ' ' of reserves over estimated periods to provide for a ^ Agoing out of use'' which does not oc- cur with any calculable reference to such esti- mates or such periods and does not undertake to burden present consumers or patrons with the cost of retiring property altogether ade- quate for their needs but not adequate for the needs of a larger number of patrons or not as economical in serving future patrons as some newly developed unit or machine. "^ 2. The course predicated on preconceived ''lives of property"; which disregards actual- ities and substitutes for business experience the theories of academicians; which creates unnecessary charges to current operating ex- penses to create unnecessary ** reserves,'' all to the end that through these accruals current passengers and shippers may be compelled to contribute to a piece-meal but surreptitious ** purchase" of the property, to be effected by the deduction of the amount of such reserves from the sum on which the company would otherwise be entitled to earn a return or the sum for which the company would be entitled to be compensated, when, if ever, the * theoretical depredationists" have their way and the Federal Government takes over rail- road property for governmental ownership and operation. -t 26 Decisions of the Courts and Regulatory Commissions Concerning These Opposing Views Although we recognize that a business problem of this character cannot be solved merely by cita- tion of judicial decisions, we believe that an analy- sis of the pertinent rulings may prove of assist- ance to the Depreciation Section and the Bureau of Accounts at this juncture. Particularly in the early years of rate litigation, it cannot be said that the Courts always perceived the problem in all its aspects or phrased their discussion of it with the exactness of expression which has come ^ with fuller consideration. It remains true that no leading or well-considered case has decided that ** accrued theoretical depreciation" must be de- ducted from the so-called ^^rate base" and pro- vided for in the rate. The trend of decision is unmistakably toward rejection of this concept altogether. As has recently been said by Ex- Judge H. M. Wright, the distinguished Special Master who has heard many of the rate cases arising on the Pacific Coast, the whole subject must be re-examined and earlier conclusions re- vised, because of the trend of judicial decisions /and recent literature. (See Pacific Gas and Elec- tric Co, vs. City and County of San Francisco; U. S. Dist. Ct; No. Dist. of Cal.; Report filed March 2, 1920; quoted from on page 71, post). One of the most recent decisions in the Federal Courts was in New 'York and Queens Gas Com- pany vs. NewtoHi, et al., in the United States Dis- trict Court for the Southern District of New York, on November 19, 1920, before Mayer, D. J., on a motion to confirm the Report and Opinion of the Honorable A. S. Gilbert as Special Master. (See 269 Fed. 277, and supplemental opinion by Mayer, D. J., not officially reported). The Special Master had ruled that there should be no deduc- 27 tion. from actual investment or present value of property, for so-called *^ expired life^' or *^ accrued theoretical depreciation/' and the Federal Court agreed with him and refused to make any such deduction. The whole issues of fact and engineering and accounting experience having to do with the main- tenance of property and the provisions to be made for renewals and replacements were exhaustively litigated in this case, and the Report and Opinion therein seem conclusively to establish the pro- priety of handling these matters in the practical business way urged in this memorandum. We quote from the opinion in that case and urge that the matters of fact therein set forth are fatal to the theoretical assumptions on which some of the proposed regulations on this subject are based: "No Deduction for 'Accrued Theoretical Depreciation* **In determining that the complainant's property has a fair present value of at least the amount of the complainant's actual in- vestment therein as found by me, viz., at least $1,655,877.94, I have made no deduction for what is termed * depreciation, ' in whatever way calculated. Under any basis of deter- mining present value, the complainant's property is now worth at least the amounJ> of such investment therein, and the sound rule of law and policy seems to require the allow- ance of a reasonable return upon at least that sum. **Upon the present trial, it was insistently urged upon me by some of the defendants that there should be deducted from the cost of the property (irrespective of whether 28 'original/ * pre-war/ or 'present reproduc- tion' cost be under consideration) an amount claimed to represent so-called 'accrued theo- retical depreciation/ based upon an assump- tion of 'life expectancy' for a gas plant and equipment and the estimated or known num- ber of years since the same was erected or installed. From the testimony given upon the trial, I was strongly impressed by the fact that in respect of a very large proportion of gas property, there is no ascertainable 'life expectancy.' The withdraw^al of such property from service comes about from in- adequacy or obsolescence which dannot be forecast in terms of years or even satisfac- torily guessed at. Certain parts of operating- machinery and equipment are of course sub- ject to effects of use. The replacement of these wearing parts enters into the cost of re- pairs. As to the substantial units of struc- tures, apparatus, mains, and equipment, their withdrawal from the property accounts comes about from causes not attributable to the con- dition of the property itself or any diminu- tion in its operating efficiency, .but varying utterly with the particular plant, time, local conditions and service demands and hence capable of being forecast only as the occasion for such change in plant or equipment be- comes imminent. "The Renewal and Replacement of Gas Property "In other words, in order to keep abreast of improvements in the art of making and distributing gas when and as it becomes eco- nomically advantageous to do so, and to meet the growing demand of the public for service more adequately and economically than would 29 be possible through merely making additions and extensions to existing plant and equip- ment, larger or better and more economical and efficient units of plant and equipment are from time to time installed to take the place of units which still are operating as efficiently as when first installed. The loss due to such supersession cannot properly be said to have accrued during the period the superseded unit was in service. It occurred when supersession took place. It became a proper charge against the economies to be realized therefrom. It furnished no basis for the imposition of an additional charge against the user of the superseded unit during the period of its use- ful service over and above the higher cost of operating it. Such a charge could not be justified either on the ground that the unit was losing potential life, or that the capital invested in it was being consumed, because neither is true. "Additional Burden on the Consumer Unwarranted *Mn order to justify the deduction of * theoretical depreciation,' I w^as asked in this case to assume that a * depreciation reserve' equal to the computed theoretical deprecia- tion' had been collected from the public, and then to deduct from the company's invest- ment the amount of such assumed reserve. No such reserve had, in fact, been collected or accumulated by this company. The rate chargeable did not permit it, and there is no reason to believe that the Legislature, in pre- scribing the rate, ever contemplated it. As I have set forth in Findings Nos. 32 and 27 iof my Keport and as I have elsewhere mdi- 30 cated herein, the complainant gas company has maintained its property and investment intact in the past, through renewals and re- placements, at an average actual cost of ap- proximately three cents per thousand cubic feet of gas sold, and no reason appears for believing that it cannot continue to do so on that basis. Even assuming that the statute permitted such a rate, to have imposed on the company's consumers an additional bur- den nearly twice as great, representing a purely theoretical item of operating cost, merely to accumulate a useless reserve to justify a drastic deduction from investment in some ultimate proceeding as to rates, could not have been justified on any sound theory in the past and cannot now be sustained as to the future. "Effects of an Unnecessary Reserve **In order to justify the assumption that a * depreciation reserve' was or should have been collected, defendants' witness Hine testi- fied in this case that such a reserve was necessary *so that when the property is re- tired for any. cause whatsoever the fund can be charged with the cost of the property. ' He testified also that the reserve should be, in his opinion, * invested in the property,' and that when the funds were needed for renewals and replacements they would be provided *by issu- ing securities against construction work w^hich had been done originally out of this fund, for the money laid aside for this fund, just to reimburse the treasury on account of these expenditures.' This view seemed to me to disregard the obvious fact that having de- ducted the amount of the reserve temporarily 31 invested in property from that on which he proposed the company should be allowed to earn a return, he, to all intents and purposes, destroyed the earning power of such prop- erty and investment; that therefore he could not issue any securities against such prop- erty, there being no earnings therefrom with which to pay interest on the securities; that the reserve could never thereafter be availed of for the purpose for which it was alleged to have been created, and that it w^ould be, in fact, as if it had never been created. Thus he not only failed to sustain his contention that a depreciation reserve' was necessary for the purposes which he alleged, but he proposed to treat the reserve as if he himself believed it to be both unnecessary and ineffectual, except for the purpose of justifying a deduction from the complainaint's investment. *^It is obvious that the collection of an un- necessary reserve and its periodic deduction from the value of the property in service would operate to effect a piece-meal purchase, on the part of the public, of the property used by the utility in its service. In other w^ords, it is really ashing the consumer to pay for the plant y instead of paying a return on the investment. If such a consummation is desirable, of which there is no evidence, it should be effected openly, and not surrepti- tiously under the guise of providing for so- called theoretical depreciation.' "Present Condition of the Property ''Mr. Miller testified that as of April, 1920, the expenditure of $6,144.07 for repairs, re- newals and replacements, would put the plant, structures, machinery and equipment in con- 32 dition substantially as good as when they were erected or installed. His testimony in this respect was not contradicted by that of any witness. This sum, however, does not, in my opinion, measure any impairment in the • present value of the property used and use- ful in the gas business. It represents merely an unmatured obligation to maintain the property in efficient operating condition out of future earnings, the expert witnesses of '- both the complainant and the defendants agreeing that it was and is maintained in effi- cient and first-class condition, I therefore have not deducted this or any other sum rep- resenting so-called * accrued depreciation' from the amount found by me to represent the investment of the complainant in its gas property upon which it is entitled to have its rate such as to yield a reasonable return.'' Judge Hand's Rejection of "Accrued Depreciation" Theories The ** straight-line " theory of *' depreciation" and the setting up of ^^ reserves "and deductions based thereon, have also been emphatically re- jected by Judge Learned Hand, in the United States District Court for the Southern District of New York (Consolidated Gas Co. vs. Neivton, 267 Fed., 231, 265; P. U. K. 1920 F, page 485). The Special Master in this case also had rejected the claim that deduction must be made for ^* accrued depreciation," in ascertaining present value. Judge Hand said: '^Maltbie figured a * straight-line ' deprecia- tion of three and a half millions, for all plants and holders. This was necessarily a conjee- 33 lure, based upon the supposed life of the plant ; it has no application while the plant is kept up, * * * *^The other elements of depreciation are for mains, about one million five hundred thousand dollars, and services and meters, one million five hundred thousand dollars. Ajiy depreciation in the mains appears to me quite fanciful. Little said that the life of a main when properly buried was indefinite ; the only question is of obsolescence and repairs, and I should suppose that obsolescence would occur only after it got too small for its re- quirements. It might of course be possible to show that all necessary mains could now be laid for less than the book cost, but the plain- tiff has shown the contrary by Miller, and it is not contradicted. *^As to meters and services the case is not so strong because even if their life be seventy- five years, as Little thinks, no one knows the age of all those in use. Moreover, the depre- ciation of one million five hundred thousand dollars is only about twelve per cent of their cost. However, the same rule applies as be- fore. The plaintiff proved the cost and the necessary repairs to bring the whole plant up to its original condition. It proved that the cost of reproducing fixtures of equal capacity was more than the book cost. That made a case, in my judgment, which was proof against any theory of * straight-line ' depreciation. The allowance for repairs might be attacked on the ground that the condition of the plants and fixtures in fact required inordinate re- pairs, but that was not done. In accordance with the principle which I have tried to dem- onstrate I decline to make any allowance for depreciation. ' ' Age of a Plant "Not a Function in Rate Base" On the broader aspects of the subject, Judge Learned Hand had occasion to consider its legal and economic aspects in the light of the more thorough and intelligent investigation which re- cent experience has prompted, and he stated his conclusions as follows: *^The defendants insist upon the element of depreciation based upon an allowance each year of that proportion of the total value which a year bears to the whole life of the plant. The Supreme Court (Knoxville Water Co. vs. Knoxville, supra, Minnesota Rate Cases, supra) has recognized that some de- preciation is a proper element in estimating the *rate base,' but has not as yet authori- tatively settled on what principle it shall be calculated. It seems to me hardly possible in the case at bar to avoid taking a position with regard to that principle. *^If the proper standard for a * rate-base' is the present cost of a substitute plant of equal capacity, as I believe, depreciation can be a function of it only in case the allowance for renewals to the plant under consideration will in the future be greater than that of the as- sumed standard. If the rates allowed in the future include only an allowance for renewals of a new plant the company will have to abate something from its normal profits because of its extraordinary renewal charges. Theoreti- cally it makes no difference whether this prob- lem is met by giving the plant a smaller value at present because of its future greater re- newal charges and then allowing a higher rate for renewals, or by giving it its present value based on capacity and letting it bear its extra renewals out of its normal profits. Were the 35 plant sold, the future abnormal renewals would be reflected in the sale price, being dis- counted at once, but that would be because the parties must at present clear their ac- counts once and for all. The seller would be unwilling at once to abate from his price, and later to allow the buyer from time to time for his unusual renewals. In the case of a public service company where the authorities may always require the plant to be kept up to standard, there is an obvious advantage in declining to attempt a repeated adjustment between the actual renewals necessary and normal renewals, as would be necessary if the present prospect of such allowances were now discounted; it is the better practice to allow the plant to bear its own extra renewals and to insist that it shall always be kept up. Therefore, it appears that, so far as concerns the future, the age of the plant should not he a function in the 'rate-base.' ^ ' On the other hand, in computing the * rate- base' from the original cost, depreciation is of vital consequence. Practical men will prefer to ascertain the cost of a present plant by experience, when they can, rather than by estimate, just as the master here has done. In so arriving at the cost of a present plant of equal capacity, it is clear that the original cost of the plant in question must be abated by depreciation, so far as that is reflected in a loss of capacity. In such a calculation, how- ever, there must figure past renewals as an offset to past depreciation and if in fact the capacity has remained the same, depreciation should not he a functidn of the 'rate hase' at all. In such a case the inquiry as to deprecia- tion should be confined to changes in * price- levels.' " 36 There heing no loss of capacity to serve, in the case of the rolling-stock, road-bed, terminals^ round-honses, and other property and equip- ment of a raihvay common carrier, through lapse of time, but probably rather an increase in ca- pacity and efficiency over previous years, and the property being in fact maintained in repair and excellent operating condition, as the statute re- quires, there is no sound reason to set up and accrue any sum for *^ accrued theoretical deprecia- tion'' or to require that this be done. The Nashville Railway Company Case (^ The so-called *' accrued theoretical deprecia- tion'' concept is in contradiction to the rulings of the United States Circuit Court of Appeals for the Sixth Circuit on December 7, 1920, in Nash- ville C. S St. L. Ry. Co. vs. United States (269 Fed., 351). In that case, the railway company had computed *^ depreciation" of roadway for the two years in question by the so-called '^straight- line" method, taking three per cent.' of the value thereof as annual depreciation on the theory that the average life of the perishable elements was thirty-three and one-third years, and had de- ducted the amount from gross income. The Gov- ernment's contention was that there was no net depreciation in the intrinsic value of the roadway and structures considered as a unit and that the deduction should not have been made. The Cir- cuit Court of Appeals sustained this view, quot- ing with approval the testimony of witnesses that 'Hhere may be depreciation in the units compris- ing the roadway, track and structures of the rail- road, while there is no depreciation in the machine as a whole;" also that it is possible '*to maintain the roadway, track and structures so that there will be no depreciation if we consider the roadway, 37 track and structures as a composite wliole;" also that ^Hhe service life of any normally operated and well maintained railroad is perpetual and it is maintained in the condition of property serving its purpose by annual renewals and replace- ^^ments. ' ' Contentions of the Government in the Nashville Case Of very great interest in connection with the foregoing decision of the United States Circuit Court of Appeals are the following excerpts from the brief filed In behalf of the United States, by way of reply to the contention of the brief submit- ted in behalf of the railroad company : *^The Government admits that there would have been depreciation to the roadway of the railway for the years 1909 and 1910 after all reasonable and proper repairs merely had been made; but the Government proved that the renewals and replacements together with the repairs which were made, maintained the roadway, and, in fact, kept the roadway in as good or better condition at the end of each of said years as it w^as in at the beginning of each of said years, and that therefore there was no depreciation, **It is the theory of the Government that the usefulness of roadways determines their value in use. In other words, as their useful- "^ ness isj so is their value. If their usefulness remains the same, their value also remains the ^ sam,e; if their usefulness is increased, their value is correspondingly increased; if their usefulness is decreased, their value is like- wise decreased. It is obvious, therefore, that whatever increases or reduces the usefulness of railroads, correspondingly increases or re- 38 duces their value. In this connection, it is well known that wear and tear, etc., reduces the usefulness, and consequently the value of railroads. On the other hand, it is equally well known that repairs, renewals, and re- placement of parts increase the usefulness and consequently the value of railroads. It is also well known that the occurrence of wear and tear is the occasion for repairs, renewals and replacements of parts, and that, with the roadway and other property properly man- aged, railway companies' wear and tear no sooner occurs than renewals and replacements are made — so that both take place simultane- ously and tend to counteract or offset each other. **When this occurs, i. e., where wear and tear suffered by railroads is sought to be off- set or counteracted by repairs, reneivals, and replacements of parts, one of three results must happen. First, if the wear and tear is exactly offset or counteracted by repairs, etc., the usefulness and value of the railroad re- mains the same and the value is said to be * maintained' intact. Second, if the wear and tear is not entirely overcome by the repairs, etc., the usefulness and value are reduced and the value is said to be depreciated' to the extent of the difference between the original and present value of the railroad. Third, if the wear and tear is more than overcome by repairs, renewals, etc., the usefulness and value is * increased' and the increased value is regarded as *an additional capital invest- ment. ' 39 ** Counsel for the railway, on page 44 of its brief, says: *The fallacy in the Government's theory is first, that it considers *^ betterments'' as a means of offsetting depreciation. This cannot properly be done; smns for better- ments are charged to capital account, not operating expenses.' The Government Proved There Is No "Accrued Depreciation" of Railway Property **The Government did not consider better- ments as a means of offsetting depreciation when sums expended for betterments were charged to the capital account of the railway. The Government proved that it is an estab- lished policy of American railways not only to maintain but to improve the usefulness and value of their roadways; and to accomplish this end, it is their practice to make repairs, renewals, and replacements of parts as occa- sion requires, ' and that as a result of such policy and practice, railways prevent or over- come depreciation in the value of their road- ways as a whole and continue the service life of their roadways indefinitely. Materials of a more modern and improved type are con- stantly being used in effecting renewals and replacements of a roadway which actually constitute an improvement or betterment which is not usually shown on the books, as will be shown from Mr. Isbell's testimony, on pages 43 and 44, which is as follows : *I do not think the deduction made by the railway for depreciation of its roadway should be allowed because in these charges for maintenance of roadway are included items for renewals and replacements. Un- 40 der the income tax law, renewals and re- placements should be charged not against expenses, but should be taken from a depre- ciation reserve, if such a reserve is on the books. It cQuld not be taken from a de- preciation reserve unless such reserve does; appear on the books. Then it is not an al- lowable expense or deduction on the income or excise tax returns, for the reason that this renewal or replacement keeps the prop- erty to its original value. As to w^hat I mean by original value, when the railroad replaces any item, they try to, according to my experience, make it as good or better. For instance, if a cross-tie is replaced, if they can get a better cross-tie to put in there, they do it. In the matter of what is technically known as other track material, consisting of such things as switches and frogs and things like that, they try to put in a better one if they have to replace an old one ; they try to put in better ballast, if possible. In that way they not only effect a renewal, but they have an improvement or betterment, which is not usually shown on the books. Of course, if they build addi- tional trackage, that is charged to capital account, and is an addition or betterment, and that does not enter into this question whatever * * * *When a tie is played out, a new tie is put in place. That is called a renewal or replacement. In the same way, if a depot needs to be rebuilt, and about the same character of structure is to be built, that is called a renewal or replacement of the de- pot, and the same thing is true of a trestle. If the trestle is replaced as near as possi- 41 ble at about the same cost as the old one, that is called a renewal or replacement of that bridge or trestle. ^If an additional track is built, for in- stance, a branch line is built to a new town or new territory, even if it is one mile or fifty miles long, that is called an addition or betterment. If a bridge costing $10,000 is replaced by a new one costing $20,000, then $10,000 is a renewal and charged to op- erating expenses, and the additional $10,000 is an addition or betterment, and that goes into the capital. It is not charged as an expense against the gross income for one year.' " The Contention of the Government as to the Effect of Renewals and Replacements ** Counsel for the railway states on page 45 of its brief as follows : *The Government gave no consideration to such repairs as painting a depot, putting window^s in machine shops, fixing the floor of a section house — that class of repairs that prolong the life of the unit repaired but cannot totally arrest its depreciation.' **Mr. Isbell, one of the Government's wit- nesses, in his answer to the following question in regard to repairs to depots, shows very plainly that repairs are taken into considera- tion (see Tr., page 47) : *Q. If a railroad company repairs a de- pot, by painting, for instance, will that arrest the functional depreciation that is accruing daily to take care of increased business in the future? 42 'A. It arrests the deterioration of the plant. It replaces the paint. It would not arrest the depreciation of any other part. That would be arrested when that other particular part might be repaired.' '' ** Since, as Mr. McKeand stated, a railroad property is of necessity a composite prop- erty, made up of individual units, the proper and only basis upon which any sane method of depreciation could possibly be figured would be upon the composite property and not upon the millions of individual units which go to make up the composite property. **In other words, as aptly expressed by the learned Trial Judge in his charge: *I further charge you, as a matter of law, construing this statute, that in that sense you should not consider each of the individual units that enter into the road- way. It was not intended to have a system of bookkeeping with reference to each par- ticular cross-tie or each particular rail, but you should look to the value of the roadway as a whole, comparing its value at the beginning of the year with its value at the end of the year' (Tr., page 104). *^If the statement of counsel for the rail- way that *it is undisputed that functional depreciation cannot be arrested, retarded or offset by repairs, renewals or replacements' were correct, then it would necessarily follow that no matter how much money was expended each year on any roadway, then it would be impossible to prevent that roadway from at some time becoming absolutely worthless, and it would have to be abandoned at some time 43 in the future. It is a matter of common knowledge that such a catastrophe never occurs, and that if a roadway is properly- maintained from day to day and month to month and year to year by the expenditure of proper amounts in making repairs, renew- als and replacements, that the life of the roadway is perpetual and that the roadway will never have to be junked as a whole or entirely rebuilt.'' ** Since the railway has admitted that its railroad is a well maintained railroad, and since one of its experts, who was called as a witness for the railway in its behalf, has sug- gested that Hhe service life of any normally operated and normally and well maintained railroad is perpetual, and it is maintained in the condition of properly serving its pur- pose by annual reneAvals and replacements,' it is apparent that the service life of the N., C & St. L. By. is perpetual and that the repairs, renewals and replacements which were 7nade to it during the years 1909 and 1910 eliminate both functional and physical depreciation or any other hind of depreci- ation which would have taken place had it not been for the repairs, renewals and re- placements which were made, as testified to by its Chief Engineer, Mr. Hunter Mc- Donald." The Basis of the 1920 Grant of Increased Freight Rates The Interstate Commerce Commission, in grant- ing the increase in freight rates effective last August (Re Increased Freight Rates, 1920, 58 44 I. C. C, 220), was required, as we understood it, to determine, in accordance with paragraph 3 of Section 15-A of the Interstate Commerce Act, as then recently amended, *Hhe aggregate property value'' of the railroads, ujx)n which a percentage constituting a fair return was to be earned under rates fixed by the Commission. There was avail- able no detailed appraisal of the railroad prop- erties, and the carriers submitted as a basis *Hhe book figures for investment in road and equip- ment, improvements on leased railway property, materials and supplies and government allocated equipment, hereinafter referred to as the book costs'' (page 227). The Interstate Commerce Commission pointed out that **The carriers recognize the infirmities inherent in the investment accounts as car- ried upon the books of the carriers, as a meas- ure of the value of the respective properties taken separately." The aggregate amount carried as book costs of road and equipment was stated to be $20,040,- 572,611 (page 228). The Commission found that *Hhe value of the steam-railway property of the carriers subject to the act held for and used in the service of transportation is, for the purposes of this particular case," approximately $18,900,000,000 (Re Increased F r eight Bates, 1920, 58 I. C. C, 220, 229). / The exact basis on which the Commission re- duced the aggregate book investment from $20,040,572,611 to $18,900,000,000 was not dis- closed in the published opinion, and has not since been made public; but it has seemed to us to be 45 obvious that the Interstate Commerce Commis- sion took no account whatever of ^^ expired life'' or ^^ accrued theoretical depreciation" in arriving at such an investment figure as representing a minimum value of the property for the purpose ^of granting emergency relief. Had any such deduction been made, the valuation would have been placed at between thirteen and fifteen billion dollars instead of at $18,900,000,000, which was but five per cent, less than the value claimed by the carriers. The Knoxville Water Company Case The Knoxville Water Company case (212 U. S., 1) is sometimes urged as authority supporting the view of the ultra-depreciationists. In that case, decided in 1909, the Supreme Court said: '*A water plant, with all its additions, be- gins to depreciate in value from the moment of its use. Before coming to the question of profit at all the company is entitled to earn a sufficient sum annually to provide not only for current repairs but for making good the depreciation and replacing the parts of the property ivhen they come to the end of their life. The company is not hound to see its property gradually waste tvithout making provision out of earnings for its replacement. It is entitled to see that from earnings the value of the property invested is kept unim- paired, so that at the end of any given term of years the original investment remains as it was at the beginning. It is not only the right of the company to make such a provi- sion, but it is its duty to its bond and stock- holders, and, in the case of a public service corporation, at least, its plain duty to the 46 public. If a different course ivere pursued the only method of providing for replace- ment of property ivhich has ceased to he use- ful ivould he hy the investment of neiv capital and the issue of new honds or stocks. This course would lead to a constantly increasing- variance between present value and bond and stock capitalization — a tendency which would inevitably lead to disaster either to the stock- holders or to the public, or both.'^ In other words, there should, of course, be at all times included in the operating expenses of a railroad or other public utility a sufficient amount to provide for the replacement and renetval of property as the need arises. The Court referred to ** making good depreciation '^ synonymously with ^* replacing the parts of the property when they come *to the end of their life.'' This does not mean that a reserve for *^ accrued depreci- ation" based on theoretical age must be provided, if provision is made for meeting all withdrawals and replacements of property when and as the need arises. If proper provision is made in oper- ating exjjenses for current replacements, and the property is kept in a high state of repair and efficiency, as railroad property is required to be maintained, both as the result of legal requirement and the exigencies of operation, the investment remains unimpaired and subject to no deduction, and no ** reserve" need be set up to create a pre- text for a reduction. The Minnesota Rate Case In the Minnesota Rate Case (230 U. S., 352), the Master had made no deduction for so-called depreciation, holding that w^hile as to certain classes of carrier property there had been depre- 47 elation in fact, yet it was more than offset by the appreciation; that the roadbed was constantly increasing in value through having become solid- ified and adjusted to surface drainage, et cetera. The Supreme Court declined to approve this dis- position of the Master, pointing out that he had also allowed a gross s "72 -2PW9 LD21A-40m-3,'72 (Qll73sl0)476-A-82 pfei^d of IrT^l'- jublect to r General Library University of California Berkeley ^ SVI& J LD 21-100to-7,'39(402,s) TU 85027 // --^ :'50473 UNIVERSITY OF CAUFORNIA LIBRARY