Opinion ID: 1188758
Heading Depth: 1
Heading Rank: 7

Heading: Other aspects of the defendant's income approach

Text: A word of explanation is required regarding problems which arise incident to the treatment of depreciation in the valuation process. If depreciation is treated as an expense of doing business (and it usually is), the rate at which any given asset is depreciated will have an effect upon net income. Also, whether a given expenditure is treated as a depreciation expense may also have an effect on net income. For example, if the owner of a business has a piece of equipment that cost $10,000, which is depreciated over a 10-year life span, there will be a depreciation expense in each of the 10 years, chargeable against income, of $1,000. If, however, the owner depreciates the property over a period of five years, the depreciation expense for each of the five years will be $2,000. Under the former procedure, the net income of the business would be reduced by $1,000 per year for 10 years; under the latter approach, the net income of the business would be reduced by $2,000 per year over a five-year term. Thus, the rate of depreciation normally has a direct relationship to net income. [6] Whether a given expenditure is treated as an expense of doing business, i.e., expensed, or as a capital acquisition may also have an effect upon the net income of the business. For example, under appropriate ICC regulations, the plaintiffs charged as an expense of doing business all expenditures for such things as ties, rails, ballast, track laying and surfacing, and other track material. The 1975 Burlington Northern annual report to the ICC shows that in 1975 it spent in excess of $19,600,000 for replacement of rails alone. The defendant's appraiser was critical of basing value under the Income approach on an accounting system in which such expenditures were expensed rather than capitalized. In his appraisal report he stated: The reported net railway operating incomes prepared by railroads in accordance with the ICC Uniform System of Accounts provides an improper basis for estimating an income to be capitalized. The ICC requires railroads to use a retirement  replacement  betterment accounting system for track structure   and a depreciation accounting system for all other depreciable properties. Thus, in those years when a railroad implements an accelerating track rehabilitation program and the total amounts for such track structure replacements in kind are entered in expense accounts in the year of installation, reported net railway operating incomes decline. In the past several years rapidly rising material and labor prices for track structure caused by inflation have magnified this effect on net railway operating incomes. Capitalized income values developed from such declining net railway operating incomes would be declining while in reality the property value rises due to the rehabilitation and replacement program.    Green was also critical of the ICC-approved practice of permitting a railroad to accelerate depreciation for tax purposes, thus inflating expenses during the early stage of life of depreciating property. Green also criticized the ICC-approved practice of expensing the cost of acquisition of units of property having a value less than $1,500, and the ICC-approved practice of charging all federal income tax expense against rail transportation income. The evidence showed that approximately half of the net revenue of Burlington Northern between 1971 and 1976 arose from operations other than railroad operations. Accordingly, Richard Green adjusted the net income figures upward over threefold. Starting with a figure of $56,000,000 as the probable future average annual net railway operating income, he added $131,252,000 to that figure on the theory that depreciation charges in that amount had been improperly included as an expense of operation. Green's conclusion was that the total income to capitalize was $187,252,000. Having determined the total income to capitalize, following the annuity method described above, he determined the market value under the income approach to be $1,673,280,000. [7] A substantial part of Green's value determination turns on the correctness of his assumption that $131,252,000 was improperly expensed. [8] Richard Green testified that although it may have been proper for the railroads to expense part of these sums under appropriate ICC regulations, in determining the value of property it was improper to treat all such expenses as a reduction from gross income. In his report he stated that the result of this was to decrease net railway operating incomes    while in reality the property value rises due to the rehabilitation and replacement program. Green therefore increased the net income from $56,000,000 to $187,000,000. See Appendix A below. There may well be a measure of truth to the statement that the property increased in value due to the repairs made. The record shows, for example, that the life expectancy of a railroad tie is 50 years. A roadway with new rails and ties would seem to be worth more than the roadway which was repaired. [9] Normally, when dealing with assets having a useful life of more than one year, good business accounting and tax law require that the cost of the asset be spread out as an expense of operation over the years that the asset is used. Normally, the full cost of such assets is not expensed in the year of acquisition, but is capitalized and recovered through depreciation deductions. It is often difficult to decide whether expenditures relating to an asset should be treated as current expense or added to the balance sheet as an addition to capital. Federal tax law provides that repairs in the nature of replacements, to the extent that they arrest deterioration and effectively prolong the life of the asset, shall either be capitalized or be charged against the depreciation reserve account. See J. Mertens, Law of Federal Income Taxation § 25.41 (1981 Cumulative Supplement). There can be no denying that if all such expenditures are consistently treated as an expense for accounting purposes, the net result would be to lower net operating income by the amount of such expenditures. On the other hand, there can be no denying that the result of this accounting procedure is to increase net operating income in later years during which charges would otherwise be made against gross income for depreciation of such assets. If the ICC-approved accounting practices are consistently followed, over a period of time, the highs and the lows would tend to even out. This system of accounting was described by one witness as retirement-replacement-betterment accounting (RRB) as follows: A Well, betterment accounting is  is where the  since it's dealing with the track, when the track is first constructed, the cost of the track is capitalized and when  no depreciation is taken. If some track is retired, it is removed from the asset account and charged to expenses. Likewise, if some account  part of the track was replaced, it would be  the replacement would be charged to the expense account. The asset account would not be disturbed. The betterment feature of betterment-replacement accounting is  for example, if the original track was 100 pound weight that was capitalized and in a later year it was replaced with 132 pound rail, at the time of the replacement, 32  the cost of 32 pounds would be capitalized and the cost of the 100 pounds of  deemed to be replacement would be charged to expenses. Although the application of such accounting practices affects railroad net operating income, according to reports in evidence, the practice has long been recognized and accepted. A committee of the American Institute of Public Accountants studied the problem and recommended in 1957 that    no substantial useful purpose would be served by a change to depreciation-accounting techniques in the absence of evidence indicating that depreciation-maintenance procedures would provide more appropriate charges to income for the use of such property. In 1966 a committee of the American Institute of Public Accountants reconsidered the matter and recommended    that replacement accounting for ties, rails and other track materials of railroads under the jurisdiction of the Interstate Commerce Commission is a generally accepted accounting principle and is in conformity with generally accepted accounting principles. One witness testified that in 1973 and 1974, the records of one railroad were reconstructed using both RRB accounting methods and depreciation accounting methods. The conclusion was that the net income of the carrier was not substantially changed under either method. As stated above, however, over a short period of time, particularly when substantial repairs and replacements to the roadway are made, the result would be to reduce net income. The issue was recently considered by the Wisconsin courts in Soo Line R. Co. v. Wis. Dept. of Rev., 89 Wis.2d 331, 278 N.W.2d 487 (1979); affirmed, Soo Line R. Co. v. Wis. Dept. of Rev., 97 Wis.2d 56, 292 N.W.2d 869 (1980). The Wisconsin Court of Appeals held:    Where a taxpayer has consistently used a generally accepted method of accounting for legitimate business purposes and not as a device the primary purpose of which is to avoid taxation, the Department of Revenue should accept the taxpayer's accounting method when making an ad valorem assessment of the taxpayer's property. The trial court found that Soo Line's treatment of rail and tie expense as a maintenance expenditure had the effect of understating both net railroad operating property and depreciation, and that to compensate for this it was necessary to add back rail and tie expenses to net railway operating income. This was error. Soo Line's accounting procedure for rails and ties accurately represents what occurs in fact: rails and ties are constantly wearing out and are constantly replaced. A willing buyer and seller would have no reason to change Soo Line's method of accounting for its rails and ties. There was no need to change Soo Line's accounting methods by adding back rail and tie expense. Wisconsin Gas & Electric Co. v. Tax Comm., 221 Wis. 487, 503-504, 266 N.W. 186. This error necessitates a reversal of the judgment appealed from unless the Department of Revenue's assessment can be sustained through the use of a proper alternative method of appraising Soo Line's property. 278 N.W.2d at 495. A similar issue was presented in Pacific Power & Light v. Dept. of Rev., 286 Or. 529, 561, 596 P.2d 912 (1979). We there rejected an appraisal based upon the Hoskold method (see footnote 5). We cited with approval the Report of Committee on Railroad and Utility Valuation, Western States Association of Tax Administrators (1971), at 15, in which it was stated:    So at least, in closely regulated companies there is possibly a persuasive argument that the book depreciation expense is a proper allowance rather than providing for depreciation in the capitalization rate. We are not convinced that it was proper for the defendant's appraiser to so increase the estimated net income by over $130,000,000 per year. Such a method was rejected by the Wisconsin courts as a matter of law. [10] The defendant has failed to persuade us, in reviewing the evidence de novo, that RRB accounting should be rejected in this case. [11] We also note that the result of such RRB accounting may be to understate, possibly in a substantial way, the value of an operating concern, utilizing the Cost approach. For example, if a 50-year-old railroad line is replaced with new ties and new rail of the same type as previously existed, it would seem logical to conclude that the railroad line, as so repaired, is substantially more valuable than the railroad line as it existed prior to the repair. Moreover, the record in this case does not permit us to speculate as to the amount, if any, by which the improved condition of the plaintiffs' properties affects the fair market value of the properties under a Cost approach. A related question is whether valuation under the Income approach should be determined before or after depreciation deductions have been made. Both of the plaintiffs' appraisers made their determination of value under the Income approach after depreciation. Under the facts of this case, we think that that approach is proper. An investor contemplating the purchase of these railroads would look at the after-tax, after-depreciation income to determine the anticipated net return. If the would-be buyer anticipated a net return of 10 percent, the buyer would likely make the calculations after depreciation and after payment of taxes. [12]