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 Age ↓ Year → t-1tt+1t+2t

12 Fig. 1- Decomposing Declines in Market Value Age ↓ Year → t-1tt+1t+2t

13 Fig. 1- Decomposing Declines in Market Value Age ↓ Year → t-1tt+1t+2t ↓

14 Fig. 1- Decomposing Declines in Market Value Age ↓ Year → t-1tt+1t+2t → 80

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.