Economic discussion on depreciation theory and accounting methods

of both factors (human and physical capital) drives net output down. Comparison between net income and gross realized income can mislead. Piketty is right about the data, but wrong about its interpretation. Depreciation Theory This is the explanation I promised when | said that depreciation is essentially like amortization. Accounting tends to practice straight-line depreciation over standard depreciation periods. A well-known refinement, allowed but not much practiced in business, is called current cost accounting. The idea is to correct distortions due to past inflation. The problem is that books reflect long-term assets and their depreciation at original cost at date of booking. Current cost accounting adjusts both to the equivalent in current dollars. It shows both net worth and depreciation as higher if prices inflated since booking, or lower if prices deflated. That seems to make sense. A further adjustment called replacement cost accounting does the same, but also replaces linear depreciation with a curve believed more realistic. National accounts adopt this method. It is sound in principle. But they shape the curve in the wrong direction. They rely on records of actual sales of plant to model depreciation as steep initially and slower later. I suggest that this record is misleading. My starting point is that value of any capital is discounted cash flow. To keep things simple at first, suppose that cash flow in constant dollars is expected to hold steady for fifty years before asset life ends. Also suppose a constant time discount rate. Present value at the outset is fifty years of discounted cash flow. At the beginning of the second year, it is 49 years present value of the same cash flow at the same discount rate. All that has been lost is present value of the 50 and most-discounted year. At the start of the third year, capital has dropped again by present value of the 49th and second-most discounted year. So it continues until the end as the discount Chapter 2: Fast Forward 1/06/16 20 HOUSE_OVERSIGHT_010960