VI. THE PRODUCTION ACCOUNT
I. Consumption of fixed capital (K.1)
1. Introduction
| 6.179. | Consumption of fixed capital is a cost of production. It may be defined in general terms as the decline, during the course of the accounting period, in the current value of the stock of fixed assets owned and used by a producer as a result of physical deterioration, normal obsolescence or normal accidental damage. It excludes the value of fixed assets destroyed by acts of war or exceptional events such as major natural disasters which occur very infrequently. Such losses are recorded in the System in the account for "Other changes in the volume of assets". Consumption of fixed capital is defined in the System in a way that is intended to be theoretically appropriate and relevant for purposes of economic analysis. Its value may deviate considerably from depreciation as recorded in business accounts or as allowed for taxation purposes, especially when there is inflation. |
| 6.180. | Fixed assets may have been purchased in the past at times when both relative prices and the general price level were very different from prices in the current period. In order to be consistent with the other entries in the same production account, consumption of fixed capital must be valued with reference to the same overall set of current prices as that used to value output and intermediate consumption. Consumption of fixed capital should reflect underlying resource costs and relative demands at the time the production takes place. It should therefore be calculated using the actual or estimated prices and rentals of fixed assets prevailing at that time and not at the times the goods were originally acquired. The "historic costs" of fixed assets, i.e., the prices originally paid for them, may become quite irrelevant for the calculation of consumption of fixed capital if prices change sufficiently over time. |
2. Consumption of fixed capital and rentals on fixed assets
| 6.181. | The rental is the amount payable by the user of a fixed asset to its owner, under an operating lease or similar contract, for the right to use that asset in production for a specified period of time. The rental needs to be large enough to cover not only the reduction in the value of the asset over that period - i.e., the consumption of fixed capital - but also the interest costs on the value of the asset at the start of the period and any other costs incurred by the owner. The interest costs may consist either of actual interest paid on borrowed funds or the loss of interest incurred as a result of investing own funds in the purchase of the fixed asset instead of a financial asset. Whether owned or rented, the full cost of using the fixed asset in production is measured by the actual or imputed rental on the asset and not by consumption of fixed capital alone. When the asset is actually rented under an operating lease or similar contract, the rental is recorded under intermediate consumption as the purchase of a service produced by the lessor. When the user and the owner are one and the same unit, consumption of fixed capital represents only part of the cost of using the asset. |
| 6.182. | The value of a fixed asset to its owner at any point of time is determined by the present value of the future rentals (i.e., the sum of the discounted values of the stream of future rentals) that can be expected over its remaining service life. Consumption of fixed capital is therefore measured by the decrease, between the beginning and the end of the current accounting period, in the present value of the remaining sequence of rentals. The extent of the decrease will be influenced not only by the amount by which the efficiency of the asset may have declined during the current period but also by the shortening of its service life and the rate at which its economic efficiency declines over its remaining service life. The flow of future rentals which determine the present values used to derive consumption of fixed capital must, of course, be valued at current prices or rentals. |
| 6.183. | The calculation of consumption of fixed capital is a forward-looking measure that is determined by future, and not past, events. The future rentals on which its value depend themselves depend upon the benefits which institutional units expect to derive in the future from using the asset in production over the remainder of its service life. Unlike depreciation as usually calculated in business accounts, consumption of fixed capital is not, at least in principle, a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods. The value of a fixed asset at a given moment in time depends only on the remaining benefits to be derived from its use, and consumption of fixed capital must be based on values calculated in this way. |
3. The calculation of consumption of fixed capital
| 6.184. | Depreciation as recorded in business accounts may not provide the right kind of information for the calculation of consumption of fixed capital, for the reasons given above. If data on depreciation are used, they must, at the very least, be adjusted from historic costs to current prices. However, depreciation allowances for tax purposes have often been grossly manipulated in quite arbitrary ways to try to influence rates of investment and are best ignored altogether in many cases. It is therefore recommended that independent estimates of consumption of fixed capital should be compiled in conjunction with estimates of the capital stock. These can be built up from data on gross fixed capital formation in the past combined with estimates of the rates at which the efficiency of fixed assets decline over their service lives. As a result of market forces, the purchaser's price of a new fixed asset should provide a good initial estimate of the present value of the future rentals which can be derived from it. Subsequent changes in its value can then be deduced analytically from information or assumptions about the rate at which its efficiency in production declines over time. This method of building up estimates of the capital stock and changes in the capital stock over time is known as the perpetual inventory method, or PIM. Estimates of consumption of fixed capital are obtained as a by-product of the PIM. |
4. The coverage of consumption of fixed capital
| 6.185. | Capital consumption is calculated for all fixed assets - that is, tangible and intangible fixed assets - owned by producers, but not for valuables (precious metals, precious stones, etc.) that are acquired precisely because their value, in real terms, is not expected to decline over time. Fixed assets must themselves have been produced as outputs from processes of production as defined in the System. Consumption of fixed capital does not, therefore, cover the depletion or degradation of non-produced assets such as land, mineral or other deposits, or coal, oil, or natural gas. |
| 6.186. | Capital consumption must, however, be calculated in respect of fixed assets which are constructed to improve land, such as drainage systems, dykes, or breakwaters or on assets which are constructed on or through land - roads, railway tracks, tunnels, dams, etc. Although some structures such as roads or railway tracks may appear to have infinite lives if properly maintained, it must be remembered that the value of assets may decline not merely because they deteriorate physically but because of a decrease in the demand for their services as a result of technical progress and the appearance of new substitutes for them. In practice, many structures, including roads and railway tracks, are scrapped or demolished because they have become obsolete. Even though the estimated service lives may be very long for some structures, such as roads, bridges, dams, etc., they cannot be assumed to be infinite. Thus, capital consumption needs to be calculated for all types of structures, including those owned and maintained by government units, as well as machinery and equipment. |
| 6.187. | Losses of fixed assets due to normal accidental damage are also included under consumption of fixed capital; that is, damage caused to assets used in production resulting from their exposure to the risk of fires, storms, accidents due to human errors, etc. When these kinds of accidents occur with predictable regularity they are taken into account in calculating the average service lives of the goods in question. At the level of the economy as a whole, the actual normal accidental damage within a given accounting period may be expected to be equal, or close, to the average. However, for an individual unit, or group of units, any difference between the average and the actual normal accidental damage within a given period is recorded in the other changes in volume of assets account. On the other hand, losses due to war or to major natural disasters which occur very infrequently - major earthquakes, volcanic eruptions, tidal waves, exceptionally severe hurricanes, etc. - are not included under consumption of fixed capital. There is no reason for such losses to be charged in the production account as costs of production. The values of the assets lost in these ways are recorded in the other changes in volume of assets account. Similarly, although consumption of fixed capital includes reductions in the value of fixed assets resulting from normal, expected rates of obsolescence, it should not include losses due to unexpected technological developments that may significantly shorten the service lives of a group of existing fixed assets. Such losses are treated in the same way as losses due to above average rates of normal accidental damage. In practice, however, it may be difficult to measure such losses. |
5. The perpetual inventory method
| 6.188. | A brief explanation of how consumption of fixed capital may be calculated as a by-product of the perpetual inventory method of calculating the capital stock is given in this section. |
Calculation of the gross capital stock at current prices
| 6.189. | The perpetual inventory method requires an estimate to be made of the stock of fixed assets in existence and in the hands of producers. This is done by estimating how many of the fixed assets installed as a result of gross fixed capital formation undertaken in previous years have survived to the current period. Average service lives, or survival functions, based on observations or technical studies may be applied to past investments for this purpose. Fixed assets purchased at different prices in the past have then to be revalued at the prices of the current period. This may be done by utilizing appropriate price indices for fixed assets. The construction of suitable price indices covering long periods of time raises difficult conceptual and practical problems, but these technical problems of price measurement are not peculiar to the PIM method and will not be pursued further in the present context. The stock of fixed assets surviving from past investment and revalued at the purchasers' prices of the current period is described as the gross capital stock. The gross capital stock can also be measured at the prices of some base year if it is desired to have annual time series for the gross capital stock at constant prices. |
Relative efficiencies and rentals
| 6.190. | The inputs into production obtained from the use of a given fixed asset tend to diminish over time. The rate at which the efficiency declines may vary from one type of asset to another. Various profiles are possible; for example:
(a) Constant efficiency until the asset disintegrates: for example, an electric light bulb;
(b) A linear decline in efficiency: the service life ends when efficiency declines to zero;
(c) A constant geometric, or exponential, decline in efficiency.
In each of these cases, it is sufficient to know one parameter, the length of the service life or the rate of geometric decline, in order to have full information about the pattern of relative efficiency over time. |
| 6.191. | Another plausible profile is a combination of cases (a) and (b) above; i.e., a linear rate of decline with the asset disintegrating before efficiency has fallen to zero. This mixed case will be referred to later. |
| 6.192. | The amounts of rentals which users are prepared to pay will be proportional to the relative efficiencies of the assets. If one is twice as efficient as another for the user's purposes, the user will be prepared to pay a rental which is also twice as great. Thus, the efficiency profiles of fixed assets determine the profiles of the rentals which they command over their service lives (assuming that prices remain, or are held, constant). Once the profiles of the rentals over the service lives of the fixed asset have been determined, it becomes possible to calculate the consumption of fixed capital, period by period. |
Rates of capital consumption
| 6.193. | Consumption of fixed capital is proportional to the reduction in the present value of the remaining rentals, as explained earlier. This reduction, and the rate at which it takes place over time, must be clearly distinguished from the decline in the efficiency of the capital assets themselves. The distinction is most obvious in the first case listed in paragraph 6.190. Although the efficiency, and hence the rental, of an asset may remain constant from period to period until it disintegrates, the capital consumption is not constant. It can easily be shown in this case that the decline in the present value of the remaining rentals from period to period is considerably lower earlier in the life of the asset than when the asset is approaching the end of its life. Capital consumption tends to increase as the asset gets older even though the efficiency and rental remain constant to the end. However, the gradual increase in capital consumption could be eliminated if the efficiency and rentals were tending to decrease over time even before the asset disintegrates. This is the mixed case referred to above obtained by combining profiles (a) and (b) so that the rentals fall at a linear rate to a cut-off point before they reach zero. It can easily be demonstrated that this kind of profile is capable of generating a constant amount of capital consumption over the life of the asset. In other words, it can lead to constant or "straight-line depreciation" as it is commonly described. |
| 6.194. | One major advantage of straight-line depreciation is its simplicity. It can be estimated merely by dividing the purchaser's price of a new fixed asset by the number of years of service life, assuming that the purchaser's price of a new asset approximates the present value of the future rentals. From a theoretical point of view, the validity of straight-line depreciation depends upon whether it is reasonable to assume some combination of profiles (a) and (b) for the rentals. Because of its simplicity, straight-line depreciation is widely used in business accounting. In principle, it is also acceptable for purposes of calculating consumption of fixed capital in the System, provided that the implied profile for the rentals is believed to be not unrealistic. |
| 6.195. | On the other hand, when the efficiency and rentals on a fixed asset decline at a constant geometric rate from period to period it can easily be shown that capital consumption also declines at the same rate. The coincidence between the two rates is extremely convenient analytically and this case figures prominently in the theoretical literature. It is also easy to calculate. In theory the life of an asset is infinite under geometric depreciation. However, when an asset has an observed average service life of n years, a good approximation to geometric depreciation can be obtained by calculating the rate of depreciation as a constant fraction, 2/n, of the written down value of the good at the start of each year. This is the so-called double declining balance method. |
| 6.196. | The rate of depreciation using the double-declining balance method is obviously twice that of linear depreciation in the first year. However, the absolute value of capital consumption declines from year to year under any geometric, or declining balance, formula, so that at some point it must fall below the corresponding figure that would be obtained using straight-line depreciation. In other words, the double-declining balance method leads to a much more "accelerated" pattern of capital consumption. This profile is considered to be more realistic by many economists, and observations on the prices of many existing tangible fixed assets tend to support it. Many business accountants also prefer an accelerated depreciation method as being more "prudent" because it tends to lead to lower values for assets in the balance sheet. |
| 6.197. | Both the linear and the geometric, or declining-balance, methods are easy to apply. The choice between them depends upon knowledge, or assumptions, about the implied profiles of rentals which underlie them. It is not possible on a priori grounds to recommend the use of one in preference to the other in all circumstances. It is possible, for example, that linear depreciation may be realistic in the case of structures, while geometric depreciation is more realistic in the case of machinery or equipment. In practice, the choice of formula seems to rest between one or other of these two methods, and there seems little justification for the use of more complex formulae. |
Values of consumption of fixed capital
| 6.198. | The value of the capital consumption on a fixed asset may be estimated by applying either the linear or geometric depreciation formula to the actual or estimated current purchaser's price of a new asset of the same type. In the case of geometric depreciation, the absolute value of the consumption of fixed capital depends on the age of the asset in question, but not, of course, in the case of linear depreciation. Consumption of fixed capital has to be calculated in this way for all the fixed assets which make up the gross capital stock valued at current prices. The consumption of fixed capital for a particular sector or industry is then obtained as the sum of the estimates for all the fixed assets owned by the units in that sector or industry. |
Gross and net capital stocks
| 6.199. | The value at current prices of the gross capital stock is obtained by making use of price indices for fixed assets to value all fixed assets still in use at the actual or estimated current purchasers' prices for new assets of the same type, irrespective of the age of the assets. The net, or written-down value of a fixed asset is equal to the actual or estimated current purchaser's price of a new asset of the same type less the cumulative value of the consumption of fixed capital accrued up to that point in time. The values in earlier periods must, of course, all be calculated with reference to the current purchaser's price of a new asset for this purpose. The sum of the written-down values of all the fixed assets still in use is described as the net capital stock. |
| 6.200. | Fixed assets figure prominently in the balance sheets of their owners. The values to be recorded in the balance sheets of the System are the net, or written-down values just described. To be precise, the value of a fixed asset shown in the balance sheet is the actual or estimated purchaser's price of a new asset of that type at the time the balance sheet is drawn up less the cumulative consumption of fixed capital incurred up to that time calculated with reference to the same purchaser's price. |
6. "Gross" and "net" recording
| 6.201. | The consumption of fixed capital is one of the most important elements in the System. In most cases, when a distinction is drawn between "gross" and "net" recording "gross" means without deducting consumption of fixed capital while recording "net" means after deducting consumption of fixed capital. In particular, all the major balancing items in the accounts from value added through to saving may be recorded gross or net: i.e., before or after deducting consumption of fixed capital. It should also be noted that consumption of fixed capital is typically quite large compared with most of the net balancing items. It may account for 10 per cent or more of total GDP. |
| 6.202. | It is clear from the previous sections that the consumption of fixed capital is one of the most difficult items in the accounts to measure and estimate. The depreciation figures recorded in business accounts, or allowed for tax purposes, may be very difficult to adjust to bring them into line with consumption of fixed capital as understood in economic theory and defined in the System, while it may not be possible to estimate consumption of fixed capital using the perpetual inventory method if long time series of gross fixed capital formation are not available in some detail. Moreover, consumption of fixed capital does not represent the aggregate value of a set of transactions. It is an imputed value whose economic significance is different from entries in the accounts based mainly on market transactions. |
| 6.203. | For these reasons, the major balancing items in national accounts have always tended to be recorded both gross and net of consumption of fixed capital. This tradition is continued in the System where provision is also made for balancing items from value added through to saving to be recorded both ways. In general, the gross figure is obviously the easier to estimate and may, therefore, be more reliable, but the net figure is usually the one that is conceptually more appropriate and relevant for analytical purposes. |
|
