Accounting for Obsolescence:

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Accounting for Obsolescence

• An Evaluation of Current NIPA Practice
• The measurement of capital is one of the
  nastiest jobs that economists have set to
  statisticians. J.R. Hicks (1969)

Arnold J . Katz The 2008 World Congress on
National Accounts and Economic Performance
Measures for Nations Arlington, VA. May 13-17,
2008
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Organization of Presentation

• Introduction How depreciation and unexpected
  obsolescence differ.
• BEAs methodology for capital stocks and
  depreciation how it handles quality change and
  expected obsolescence .
• Key points of the underlying economic theory.
• Causes of unexpected obsolescence.
• An evaluation of possible accounting treatments
  for it.

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Depreciation vs. Obsolescence

• BEA defines depreciation as the decline in the
  value of the stock of assets due to wear and
  tear, obsolescence, accidental damage, and aging.
• Declines in value due to unexpected obsolescence
  are generally sharper.
• They may result from factors that do not affect
  depreciation.
• Differences between the two concepts will become
  clearer over the course of this presentation.

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BEAs Perpetual Inventory Method-I

• With the method, net stocks and depreciation are
  weighted averages of past investment.
• Investment in current prices is converted to
  investment in constant prices using a
  constant-quality price index.
• Constant-price stocks are the product of past
  constant-price investment and the relevant value
  from each durables age-price profile.
• Asset lives are service lives, not physical
  lives.

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Age-price Profiles

• BEAs age-price profiles are theoretical ratios
  that are pre-determined.

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Perpetual Inventory Method- II

• Depreciation is estimated using the prices used
  to value the stock.
• Current-price estimates are obtained by
  reflation.

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Constant-price Properties

• Over an assets lifetime, depreciation charges
  sum to initial purchase price.
• Change in net stock gross investment less
  depreciation.
• These imply that net investment is zero in a
  steady state where gross investment has been
  constant.

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Treatment of Quality Change

• An increase in the quality of new investment
  increases the quantity and reduces the price of
  new investment.
• It has no effect on the constant-price stock of
  older vintages and, therefore, increases the
  entire stock.
• It reduces the current-price value of older
  vintages and, therefore, the entire stock.
• Similar results hold for measured depreciation.

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Theory I - Maintaining Capital Intact

• Pigou said that it was the quantity of capital
  that must be maintained intact the property
  that net investment is zero in a steady state is
  consistent with this.
• Hayek said physical lives were irrelevant and
  that expected obsolescence was part of
  depreciation - BEAs use of service rather than
  physical lives is consistent with this.

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Theory II Jorgensons Capital Accounting
Framework

• Cornerstone is the fundamental equation of
  capital theory the price of an asset is the
  discounted present value of the net income to be
  derived from owning it.
• Depreciation is measured as the difference in
  price of two assets that differ solely in their
  age.
• The decline in an assets market value can be
  decomposed into depreciation and capital gain
  components.

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Fig. 1- Decomposing Declines in Market Value
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Fig. 1- Decomposing Declines in Market Value
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Fig. 1- Decomposing Declines in Market Value
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Fig. 1- Decomposing Declines in Market Value
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Using One or Two Age-Price Profiles

• In BEAs estimates and in Jorgensons work, the
  two prices used to estimate depreciation come
  from identical age-price profiles. As a result,
  they share the property that constant-price
  estimates of depreciation sum up over the
  lifetime of an asset to the assets purchase
  price.
• In many empirical studies, the two prices are not
  forced to come from identical age-price profiles.
• Frank Wykoff has recently labeled as
  "obsolescence" the difference between two
  estimates of depreciation, where one's prices
  come solely from identical age-price profiles and
  where the second's come from two different
  age-price profiles.

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Definition of Unexpected Obsolescence

• Proposed Definition - Unexpected obsolescence is
  a sharp decline in the value of an asset due to
  factors other than physical damage,
  deterioration, aging, and the passage of time.

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Causes of Unexpected Obsolescence

• Unavailability of required inputs.
• Increase in relative price of required inputs.
• Increase of relative cost of making repairs.
• Prolonged increase in interest rates.
• Tax credits for new investment.
• Regardless of the cause, expected obsolescence is
  embodied in our estimates of depreciation. Its
  effects can not be separated from other causes of
  depreciation.

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Treatments for Unexpected Obsolescence

• Replace ex ante depreciation patterns with ex
  post ones.
• Treat differences between the actual and expected
  value of used assets as an other change in the
  value of assets.
• Same as above, but use normal values for expected
  ones.
• Write off only losses due to large-scale
  obsolescence as an other change in the volume of
  assets.
• In deciding on a treatment, we need to reduce the
  amount of subjectivity in it and avoid biasing
  the measure of net investment.