Replacement Costs and Accounting Reform in Post-World War I Germany

Graeme Dean, Frank Clarke, Finley Graves

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351852784
• Edition: 1
• Topic: Economics
• Subtopic: Economic History
• Index: Economics

Originally published in 1990, this anthology of articles from the German financial and industrial press, translated into English for this volume, discusses the socio/politico/economic background that was a catalyst for the development of replacement cost accounting ideas in Europe and Anglo-American countries. The contributions to the replacement cost debate contained in this anthology, in general, defended depeciation and cost accumulation based on replacement cost. If industry and the German economy were to prosper in a time of social, economic and political chaos in the immediate post World War I period, replacement cost accounting was considered essential.

III. REPLACEMENT COSTS AND GERMAN ACCOUNTING REFORM: TRANSLATIONS

1. Depreciation and Inflation*

Dr. W. Prion

Professor at the University of Cologne

Depreciation, which the businessman recognizes annually on long-term plant and equipment, is based on the simple idea of setting aside a sufficient amount of annual sales revenue to cover replacement or reproduction cost of plant assets when they are retired. If liquidation of an enterprise is anticipated, the monetary capital invested in productive assets (whose productive capacity is now exhausted) must have been earned or won back from sales. The textbook example is well known: the historical cost of a machine is 10,000 M.; its useful life, 10 years; its salvage value, 1,000 M. Depreciation in this case amounts to 900 M. annually for ten years. At the end of the tenth year - disregarding the effect of compound interest -

1.	salvage value	=	1,000 M.
2.	cash: 10 x 900 M.	=	9,000 M.
			10,000 M.

will be on hand.

But since enterprise continuity is the general rule, the 10,000 M. must serve to purchase a new machine of the same kind and quality and the same economic significance as the worn-out machine. The great stability of prices before the war, along with the tendency for prices to fall as a result of mass production, did much to reinforce the idea that accumulated depreciation represented a plant replacement fund. Of course technical innovation or increased efficiency may lead the manager to purchase a more expensive - and better - machine in place of the old, retired machine. But in this case, as a matter of principle, the additional cost of the new machine would have to be recovered from sales of the goods produced by the new machine, that is, the additional cost will at first have to be funded from capital. Increasing annual depreciation on the old machine to cover the cost of the new machine did not correspond to the understanding of depreciation at the time. In other words, depreciation was not based on replacement cost, which could only be estimated in any event. The cost of the old machine was to be recovered from the revenues generated by the old machine. The goods produced by the new machine, accordingly, had to bear the cost of depreciation for the new - more expensive - machine. If caution and prudence on the part of the businessman often led him to depart from this principle and actually depreciate more or less on the basis of replacement cost, all the less reason to object since this procedure benefited the financial security of the enterprise. Besides, the practice generally found a natural limit in peace-time prices which fluctuated only rarely.

Inflation twisted this principle in two directions:

1. Plant assets purchased before the war and in the early war years often remain on the books at their old values, that is, in gold marks. Is depreciation even necessary in these cases? Apparently not according to the theory of “value depreciation”; for in terms of today’s paper marks such plant assets are worth many times their book values. One could discontinue depreciation on these assets until, through the process of wear and tear, their book values coincided with their current or market values expressed in paper marks. In many cases, however, such coincidence would not be attained since the salvage value of plant assets in terms of paper marks is often still greater than their book value expressed in terms of gold marks. Future paper-mark proceeds in these cases would be greater than values reflected in the books. Accounting gains would result even though depreciation had been discontinued. If one views matters in this way as a matter of principle continuing to depreciate plant assets increases the difference between the assets’ gold-mark book values and their values in terms of paper marks or the actual proceeds from their eventual disposal.

But viewing matters in this way fails to take into account that these residual values, even if they are numerically higher than their current book values, are only paper-mark representations that do not cover replacement. For replacement cost in paper marks is ten to twenty times greater the original cost, that is, it may be 40 to 50 times its current book value or future residual value. It follows that depreciation that has been recognized on the gold-mark value of plant assets no longer has the same meaning or purchasing power. It, too, has taken on the characteristics of paper marks - in an arithmetical sense at least - and can regain its former purchasing power only by means of additional allocations from reserves, profits, or capital. The following example will illustrate.

If a machine that was purchased before the war for one million marks and has a book value of 700,000 marks at the end of 1918 and costs 20 million marks to replace at the outset of 1920, an annual depreciation rate of 50,000 marks would not suffice to accumulate the 20 million marks in 20 years. Nor are the 300,000 marks accumulated over the 6 years 1914–20 more than 300,000 paper marks, that is, not even ⅓ of the one million paper marks necessary each year to cover the 20 million mark replacement cost. It follows that in recognizing depreciation on plant assets whose book values are expressed in gold marks a multiple of the amount previously charged - a multiple corresponding to the rate of inflation - should be booked. The matter would be clear and simple if the old values were restated in terms of paper marks and depreciation were recognized on the paper-mark values. It would then be perfectly clear that depreciation had been increased merely because of inflation and must be increased if the enterprise is to accumulate sufficient funds for plant replacement and thus enterprise continuity. Restatement of plant assets in terms of paper marks is neither customary nor feasible at present, yet managers are aware of the paper-money character of depreciation and tend to act accordingly. It is not surprising therefore, that depreciation has seemed especially high recently.¹

Above all, however, one should expect timely recognition of the internal change in depreciation on the part of the tax authorities. Namely, to the extent that depreciation has increased in proportion to inflation - an increase that under certain circumstances can be considerable -, [the income offset] should be tax-exempt, just as any genuine depreciation charge reduces taxable income. Of course in particular cases the extent to which increases in depreciation are justified and thus tax-exempt will not be easy to establish. (We will return to this point.) But as a matter of principle, taxes on income should be paid from actual income and not from capital. The latter circumstance is the case, however, if inflation is not taken into account in calculating depreciation.

Just as obvious as the need for an increase in annual depreciation is the need for an allowance for these higher depreciation charges in setting prices. Proceeds from sales of goods today occur as paper marks. A businessman who uses past depreciation rates in setting prices realizes them in paper marks and thus places himself in the position of not being able to pay the higher replacement costs of plant assets. The main misgivings regarding the allowance for higher paper-mark depreciation charges in the price formation process include not only the fact that during periods of changing prices future replacement costs may be quite arbitrarily set, but the fact that a tendency may emerge to accelerate the depreciable lives of assets to the greatest extent possible - from twenty years to ten years or even five or three years; in other words, to increase correspondingly the amount of depreciation per year and thus the surcharges for price formation purposes currently. During periods of inflation these increases mean an additional, powerful stimulus for further price increases; a shifting of the components of future prices to goods manufactured currently; an intensification of inflation at the most inauspicious of moments. If there are also businessmen who then add additional surcharges for possible price declines “relative to goods currently in process,” for “losses due to a decline in exchange rates,” etc., one will no doubt feel compelled to endorse an official audit or other price verification procedure as a matter of principle. On the other hand, prices driven high by this costing process will be even more adversely affected by a downswing in the economy. Ruinous price fluctuations, therefore, are as a rule magnified by such costing behavior.

2. Accounting for depreciation, however, takes on quite a different face during inflation. If as a matter of principle one calculates depreciation on the basis of replacement cost - at present in terms of today’s inflated paper marks -, that is, calculates depreciation for the same asset with the same productive capacity and allocates it over the same number of years, always adjusting the amount for changes in the replacement cost of the asset, the gold-mark accounts may soon run out of room for the annual paper-mark depreciation amounts. In our example, the historical cost of the asset was 1,000,000 M., depreciation over six years, 300,000 M., and the book value at the end of 1918, 700,000 M.

A remaining depreciable value of 700,000 M. cannot accommodate annual depreciation of 1,000,000 paper marks (on a replacement value of 20 million marks). This example demonstrates the absurdity of today’s customary practice of recognizing paper mark depreciation on low gold-mark values. Paper marks can only be deducted from paper marks. For this reason, depreciation today (paper-mark depreciation) should only be recognized on paper-mark accounts and not on gold-mark accounts. Thus, if restating old gold-mark accounts in terms of paper marks (as explained above) is out of the question, a replacement reserve or, if necessary, a replacement fund should be established. The accounting would appear as follows:

Debit:

Plant assets

Book value at end of 1918: 700,000 M.

Credit:

Replacement reserve

Depreciation through 1918

1. Difference due to inflation for 6 years. The 300,000 M. are to be restated by 5,700,000 M. so that 1,000,000 M. per year for six years will have been accumulated.

2. Depreciation for 1919, 1,000,000 M.

The retroactive effect of this procedure on enterprise “profit” will not be pursued here.

Clearly, then, the 6,700,000 M. set aside for replacement, when added to the old accumulated depreciation amount of 300,000 M., make up the necessary amount for 7 years in relation to a replacement cost of 20,000,000 marks depreciated over 20 years. A few firms already account substantially as illustrated above or in a similar manner. The reserves, however, usually appear under such titles as reserve account, special reserve, etc. In any case, the replacement-reserve method is not yet being applied commonly and systematically in German accounting practice. But it is only a question of time before enterprises will make use of it.²

If many companies today still shrink from using replacement accounts, especially when it comes to crediting them for the full amount necessary to replace assets, they do so because the tax authorities are wont to construe the larger sums as genuine reserves and thus declare them taxable. Given the great perils enterprises already face because their more or less purely inflationary profits are taxed away, it is a matter of broad general interest that the tax authorities soon recognize the true nature of increased depreciation. At present, widespread aversion to unconcealed replacement reserves results in further distortion of accounting data. Since, as was shown above, most plant asset accounts technically do not permit increased depreciation in paper marks, the bookkeeper looks about for other accounts that could accommodate the extra depreciation; hence the common practice of including reserve accounts among liabilities in order to conceal them. Under certain circumstances, accordingly, sizeable liabilities, which usually are not a good sign financially, represent a financial cushion, that is, plant asset replacement reserves, but only recognizable and knowable as such to the initiated. Above all, inventories, including raw material inventories, goods in process, and finished goods, have to provide content for the balance sheets businessmen want to offer the public and the tax authorities - or can afford to if they have given up hope that the tax authorities will recognize the true nature of increased depreciation. In the abstract, there is no compelling reason during periods of rising prices such as we have just experienced to value inventories, say in the balance sheet at the close of 1919, especially low. Nevertheless, one cannot blame the businessman who at that time allowed for the risk of a price decline by valuing...