Obsolescence and depreciation Issue 23 Charles Aspden OECD

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.

The issue The point of contention can be found in paragraph 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.

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.

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.

Factors contributing to price change a)Deterioration - wear and tear b)Exhaustion – as remaining service life declines c)Foreseen obsolescence d)Other changes that bear on supply and demand e)Changes in the overall price level

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).

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.

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.

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.

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?

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.

Example comparing AAS and DH depreciation An asset has a value, V 1 c, 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, V 1 k, is 400. The general price level is expected to increase by 2% year.

Example comparing AAS and DH depreciation Beginning of Period VtkVtk AASD t k 100 PtbPtb PtaPta AASD t c VtcVtc CPI t b CPI t a V t c / CPI t b DHD t r DHD t c

Example comparing AAS and DH depreciation Beginning of Period VtrVtr DHD t r 114 DHD t c

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.

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.