APPENDIX B - On Durability and Economic Depreciation

Summary

PREVIEW AND GUIDE TO THE APPENDIX

Economic depreciation, or the decline in value of an asset with time, has traditionally been associated with the physical deterioration of a capital asset and its functional obsolescence. This Appendix advances two ideas. First, an understanding of depreciation need not be based on deterioration, wear and tear, or obsolescence. Instead, it is shown that the depreciation of a capital asset between two consecutive time periods is equal to the expected incremental present value of the services provided by the asset during this time interval. Second, this Appendix provides a framework for a dynamic forecast of depreciation – a forecast that can be updated and refined as the asset is put to service until its depreciation becomes observable in a resale market. The forecast horizon for depreciation ranges between the expected useful life of an asset and zero. In the latter case, the forecast becomes “observation.” Empirical studies of depreciation are a special case within the proposed framework, where the change in an asset's value is “observed” or measured in a resale market.

Introduction

Depreciation is an important concept for accountants, economists, and financial managers, and it has received significant attention in the literature. The focus in the economics literature has been to a large extent on empirical studies of economic depreciation. These empirical studies investigate aggregate depreciation for cohorts of assets, as opposed to the value trajectory of an individual asset as it ages.