Accounting for Obsolescence:

1. 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

2. 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.

3. 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.

4. 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.

5. Age-price Profiles • BEA’s age-price profiles are theoretical ratios that are pre-determined.

6. Perpetual Inventory Method- II • Depreciation is estimated using the prices used to value the stock. • Current-price estimates are obtained by “reflation”.

7. 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.

8. 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.

9. 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.

10. 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.

11. Fig. 1- Decomposing Declines in Market Value

12. Fig. 1- Decomposing Declines in Market Value

13. Fig. 1- Decomposing Declines in Market Value

14. Fig. 1- Decomposing Declines in Market Value

15. 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.

16. 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.

17. 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.

18. 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.