In the 19th century, factories and mills were major concentrations of capital. Manufacturing completed for investment money, and business cases could be as closely examined as any other risky investment. In 1884, Edwin Matheson wrote about how maintenance affected accounting and business prospects in The Depreciation of Factories and their Valuation. Matheson’s book became the basis of modern views of depreciation.
Matheson introduced his work by saying,
The question of depreciation cannot be separated from that of maintenance, and in theory one may be said to balance the other…In any particular building, machine, or appurtenance, decay or wear of some sort must take place in the course of time, and repairs in order to compensate fully for the decline in value, must take the form of renewal.
Matheson cited R. Price Williams’ work on wear, depreciation, and life-cycle maintenance of railway tracks and locomotives. Williams had read ground-breaking papers in 1866 and 1870 before the British Institute of Mechanical Engineers. Williams was a railroad engineer and limited his work on depreciation to his own industry, but other engineers in business adopted his ideas. Williams’ first paper dealt with the lifecycle of rails and railbeds. His second paper expanded to the more complex subject of locomotives and cars. Locomotives were much more maintainable, since parts could be replaced one by one, eventually leaving nothing left of the original machine. Periodic part replacement required new thinking about the time-value of a complex assembly. (For more on Williams read here.)
Much of Matheson’s work dealt with factory buildings, but as an engineer himself, he used some examples of how precision maintenance could affect depreciation life and the actual service life of plant equipment.
Matheson discussed how important balancing high-speed rotating machinery was:
The Deterioration of machinery depends on many circumstances, some of which relate to the Machine itself, and others to the mode of Using it….For slow speeds, an approximate balancing of the moving parts may suffice, while for high velocities, when the slightest inequalities are intensified by the speed, exact balancing and the most accurate fitting are necessary to prevent the machine or its supports being shaken loose and destroyed.
Matheson also included basic operator care in his discussion:
Care in management goes far to determine the durability of a machine. Protection from dirt or injury, periodical painting, and lubricating with good oil, may render one machine twice as durable as a similar one in which these precautions are neglected.
He also recognized that higher operating pressure, extra hours from overtime, or higher machine speeds deteriorated machinery at a faster rate than was planned by simple annual depreciation practices.
In several parts of the book, Matheson commented on how “neglect of repairs” ruined the accounting assumptions of the depreciation period. If maintenance did not balance the depreciation within a fiscal period, then the asset’s book value was miscalculated for that fiscal period. Skipping maintenance made the plant look more profitable immediately, but created a backlog of both physical work and of undepreciated value. If maintenance was deferred, the correct management action was to accelerate depreciation and write off a percentage of the asset’s value.
Matheson presented a graph that summarized his concepts of depreciation over time and the balancing effects of periodic maintenance investments. The dotted lines show the depreciating value of building and plant equipment. Land appreciated slightly. The solid lines go up when repairs or maintenance were conducted, or when investments were made into the productivity of the plant.
Matheson was an engineer, but with experience in accounting of manufacturing equipment. His employer, Andrew Handyside & Co., made one of the first attempts to reduce their reported profit by the amount their equipment depreciated. Tax authorities intervened, the matter went to court, and the company eventually lost on appeal. The court’s opinion contained the principle that repair was an operational cost and should be treated differently than depreciation.
Matheson’s work on depreciation, based on R. Price-Williams’ work on repairing locomotives and replacing rails, helped establish the methods for treating repair and depreciation in the modern world.
Matheson, Ewing. The Depreciation of Factories And Their Valuation. London: E. & F.N. Spon, 1884. https://hdl.handle.net/2027/uc1.$b38117
The Law Journal Reports, vol 45 pt 2, p 810, London, Edward Bret Ince
Thanks for this article, Karl, it’s a valuable set of insights and an interesting bit of history. it’s been a while since I last looked at a corporate balance sheet. How do modern businesses factor in the cost of repairs versus the depreciation of their assets? Even “perfect” repair has its limits, so isn’t it a reasonable practice to depreciate the value of equipment over time, even when it is being repaired regularly? I suppose if it was for tax purposes, I could see why the taxman pursued the issue. I also suppose that at that time there were no allowances for reinvestment of profits in order to avoid taxation (a la Amazon).
Sorry for the jumble of thoughts, but thanks for inspiring them!
Hi Chris,
Financial treatment of maintenance varies. GAAP and IFRS have different approaches, and each company sets their own internal policies. You may see “PP&E” or “Property, Plant, and Equipment” under the depreciation section.
Companies have a capitalization limit below which they won’t capitalize and depreciate any activity. If a repair cost is lower than this, it will be treated as period expense, just like labor or a consumable.
Above the capitalization threshold, other rules may apply, like if a new capacity is added. Sometimes, adding additional service life counts as new capacity, so events like major overhauls can sometimes be capitalized and depreciated. This is normally decided by the person that has to actually sign the financial statements…face auditors…and also investors.
A common misunderstanding is that capitalization somehow improves the current month’s expense reports…it does, because the cost center spreads the expense out over time. This is also shortsighted, and burdens the cost center in the long run. Inventors have KPIs to check for this.
Some engineering managers in the 19th century thought this was mismanagement that bordered on criminality!
For lots more…see my article titled “Railway Maintenance and Depreciation” in this article series.
https://accendoreliability.com/railway-maintenance-and-depreciation