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 . KatzThe 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.

BEA’s 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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BEA’s 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 durable’s age-price profile.

▪ Asset lives are service lives, not physical lives.

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Age-price Profiles

▪ BEA’s age-price profiles are theoretical ratios that are pre-determined.

0

0.2

0.4

0.6

0.8

1

1 2 3 4 5 6 7 8 9 10

Years

Price

relat

ive

to in

itial

price

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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 asset’s 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 - BEA’s use of service rather than physical lives is consistent with this.

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Theory II – Jorgenson’s 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 asset’s market value can be decomposed into depreciation and capital gain components.

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Fig. 1- Decomposing Declines in Market Value

Age ↓ Year →

t-1 t t+1 t+2 t+3

0 100

1 90

2 80

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Fig. 1- Decomposing Declines in Market Value

Age ↓ Year →

t-1 t t+1 t+2 t+3

0 96 100

1 86 90

2 77 80

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Fig. 1- Decomposing Declines in Market Value

Age ↓ Year →

t-1 t t+1 t+2 t+3

0 96 100

1 86 ↓90

2 77 80

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Fig. 1- Decomposing Declines in Market Value

Age ↓ Year →

t-1 t t+1 t+2 t+3

0 96 100

1 86 90

2 77→ 80

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Using One or Two Age-Price Profiles

▪ In BEA’s estimates and in Jorgenson’s 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 asset’s 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.