Obsolescence and depreciation Issue 23

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Obsolescence and depreciationIssue 23

• Charles Aspden
• OECD

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Background

• The issue arose from the preparation of the OECD
  manual, Measuring Capital.
• There were different views on the treatment of
  obsolescence and the measurement of consumption
  of fixed capital (CFC) or (depreciation).
• Despite lively debate there was no resolution.
• Paradoxically, all agree with what the SNA says,
  and it is a matter of interpretation.

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The issue

• The point of contention can be found in paragraph
  10.118
• ..CFC must be measured with reference to a given
  set of prices, i.e. the average prices of the
  period. It may then be defined as the decline,
  between the beginning and end of the accounting
  period.., as a result of their physical
  deterioration and normal rates of obsolescence
  and accidental damage.

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The issue

• The bone of contention is what is meant by the
  average prices of the period.
• Ahmad, Aspden and Schreyer have argued that it
  should be with respect to a constant-quality
  price index of the asset concerned.
• This is the view advocated in Measuring Capital
  and is the one underpinning the estimation of
  depreciation by many OECD member countries.

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The issue

• It implies valuing depreciation at the average
  replacement cost of the period.
• Hill and Diewert have argued that depreciation
  should be valued with respect to a general price
  index as long as it rises faster than the
  asset-specific, constant-quality price index.

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Factors contributing to price change

1. Deterioration - wear and tear
2. Exhaustion as remaining service life declines
3. Foreseen obsolescence
4. Other changes that bear on supply and demand
5. Changes in the overall price level

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Factors contributing to price change

• Broad agreement that depreciation should include
  (a), (b) and (c).
• Agreement that depreciation should not include
  changes in the general price level.
• Different views on how (c) should be measured
  which impinge on (d).

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The opposing views

• Diewert,Hill Foreseen obsolescence should be
  equated with ANY expected real holding loss.
• Ahmad, Aspden, Schreyer Depreciation should NOT
  include any holding gains and losses.

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Conceptual issues

• DH Depreciation corresponds to a notion of
  income that measures maximum consumption in a
  period, provided that the purchasing power of the
  capital stock is kept intact. The purchasing
  power of the capital stock is measured in terms
  of an overall bundle of goods and services. A
  real holding loss marks a reduction in purchasing
  power.

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Conceptual issues

• AAS depreciation corresponds to a notion of
  income that measures maximum consumption in a
  given period, provided that the capital stock
  and therefore its productive capacity is kept
  intact. To preserve productive capacity, only
  replacement investment is required to match the
  capital used up in production.

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Practical considerations

• DH depreciation includes expected real holding
  losses, but NOT expected real holding gains,
  which makes it more difficult to implement. Which
  general price index to use? Does it matter if
  this price index reflects the effects of
  obsolescence of other goods and services?

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Practical considerations

• AAS depreciation is the one applied at present.
• Estimates of GFCF are deflated to constant prices
  using asset-specific price indexes.
• Age-price functions are used to estimate the
  value of capital stock and depreciation at
  constant prices.
• Current price values are obtained by inflating
  these values using the same asset-specific price
  indexes.

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Example comparing AAS and DH depreciation

• An asset has a value, V1c, of 450 at the
  beginning of period 1.
• It has an expected service life of 4 years.
• The price index for this type of asset is
  expected to decline by 20 a year, and so the
  value of the asset at the beginning of period 1
  in the average prices of period 1, V1k, is 400.
• The general price level is expected to increase
  by 2 year.

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Example comparing AAS and DH depreciation
Beginning of Period 1 2 3 4 5
Vtk 400 300 200 100 0
AASDtk 100 100 100 100
Ptb 1.125 0.9 0.72 0.58
Pta 1.0 0.8 0.64 0.51
AASDtc 100 80 64 51
Vtc 450 270 144 58 0
CPItb 0.99 1.01 1.03 1.05
CPIta 1.0 1.02 1.04 1.06
Vtc/ CPItb 455 267 140 55 0
DHDtr 188 127 85 55
DHDtc 188 130 88 58
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Example comparing AAS and DH depreciation
Beginning of Period 1 2 3 4 5
Vtr 455 341 227 114 0
DHDtr 114 114 114 114
DHDtc 114 116 118 121
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Recommendations

• No change of substance required to SNA text, but
  clarification needed to make it clear that
  average prices should be measured with respect to
  a constant-quality price index.
• More text should be provided explaining concepts
  underlying the SNA measure of depreciation, i.e.
  the concept of income.

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Recommendations

• More guidance should be provided on the
  implementation of depreciation measures. Such
  guidance should be integrated into the broader
  setting of a revised manual on capital
  measurement, to be prepared alongside the
  revision of the SNA.