Consumption of fixed capital
Encyclopedia
Consumption of fixed capital (CFC) is a term used in business accounts, tax assessments and national accounts
for depreciation
of fixed assets. CFC is used in preference to "depreciation" to emphasize that fixed capital is used up in the process of generating new output, and because unlike depreciation it is not valued at historic cost but at current market value (so-called "economic depreciation"); CFC may also include other expenses incurred in using or installing fixed assets beyond actual depreciation charges. Normally the term applies only to producing enterprises, but sometimes it applies also to real estate assets.
CFC refers to a depreciation
charge (or "write-off") against the gross income of a producing enterprise, which reflects the decline in value of fixed capital
being operated with. Fixed assets will decline in value after they are purchased for use in production, due to wear and tear, changed market valuation and possibly market obsolescence. Thus, CFC represents a compensation for the loss of value of fixed assets to an enterprise.
According to the 2008 manual of the United Nations System of National Accounts
,
CFC tends to increase as the asset gets older, even if the efficiency and rental remain constant to the end. The larger the depreciation write-off, the larger the gross income of a business. Consequently, business owners consider this accounting entry as very important; after all, it affects both their income, and their ability to invest.
By how much then, do fixed assets used in production truly decline in value, within an accounting period? How should they be valued? This can be arguable and very difficult to answer, and in practice, various conventions are adopted by accountants and auditors within the framework of legal rules and economic theory.
In addition, the depreciation schedules imposed by tax departments may differ from the actual depreciation of business assets at market rates. Often, governments permit depreciation write-offs higher than true depreciation, to provide an incentive to enterprises for new investment. But this is not always the case; the tax rate might sometimes be lower than the real market-based rate. Furthermore, businesses might engage in creative accounting
and deliberately state their assets and liabilities held at a balance date, or interpret the figures in some other way, to increase the amount of depreciation write-offs, and thus boost their income (how this is done will depend a lot on tax law).
For all these reasons, economists distinguish between different kinds of depreciation rates, arguing that the "true" consumption of fixed capital is really the economic depreciation, assessed by relating financial data to mathematical models, to arrive at a figure that "seems credible". The economic depreciation rate is based on observations of the average selling prices of assets at different ages. The economic depreciation rate is therefore a market-based depreciation rate, i.e. it is based on what an asset of a given age would currently sell for in the market.
or Gross Domestic Product
, and regarded as a cost of production. It is defined in general terms as the decline, in an accounting period, of 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.
The UNSNA manual notes that "The consumption of fixed capital is one of the most important elements in the System... It may account for 10 per cent or more of total GDP." CFC is defined "in a way that is theoretically appropriate and relevant for purposes of economic analysis". Its value may therefore diverge considerably from depreciation actually recorded in business accounts, or as allowed for taxation purposes, especially if there is price inflation.
In principle, CFC is calculated using the actual or estimated prices and rentals of fixed assets prevailing at the time the production takes place, and not at the times fixed assets 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.
Unlike depreciation as calculated in business accounts, CFC in national accounts is, in principle, not a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods. Rather, fixed assets at a given moment in time are valued according to the remaining benefits derived from their use.
Depreciation charges in business accounts are adjusted in national accounts from historic costs to current prices, in conjunction with estimates of the capital stock.
The net, or written-down value of a fixed capital asset is equal to its current replacement cost, less CFC accrued up to that point in time.
Thus, the criticism centres both on the valuation principles used, and the additional items included in the aggregate, which are not directly related to depreciation charges at all. Yet the whole computation strongly affects the size of the GDP figure and the aggregate profit figures provided. Because of the way CFC is calculated, aggregate profit (or operating surplus
the residual item in the product account) is likely to be understated, independently of the actual profit calculation, which is usually derived from tax data.
Ultimately, the distinction drawn between that portion of business operating expenditure included in CFC beyond depreciation, in contrast to that portion of operating expenditure included in Intermediate consumption
may appear rather capricious, rather than theoretically justified.
In Marxian economics
, the official concept of CFC is also disputed, because it is argued that CFC really should refer to the value transferred by living labor from fixed assets to new output. Consequently, operating expenditures associated with fixed assets other than depreciation should be regarded as either as circulating constant capital
, faux frais of production
or surplus value
, depending on the case. Furthermore, the measured difference between economic depreciation and actual depreciation charges will either add or lower the magnitude of total surplus value
.
National accounts
National accounts or national account systems are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry accounting...
for depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
of fixed assets. CFC is used in preference to "depreciation" to emphasize that fixed capital is used up in the process of generating new output, and because unlike depreciation it is not valued at historic cost but at current market value (so-called "economic depreciation"); CFC may also include other expenses incurred in using or installing fixed assets beyond actual depreciation charges. Normally the term applies only to producing enterprises, but sometimes it applies also to real estate assets.
CFC refers to a depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
charge (or "write-off") against the gross income of a producing enterprise, which reflects the decline in value of fixed capital
Fixed capital
Fixed capital is a concept in economics and accounting, first theoretically analysed in some depth by the economist David Ricardo. It refers to any kind of real or physical capital that is not used up in the production of a product and is contrasted with circulating capital such as raw materials,...
being operated with. Fixed assets will decline in value after they are purchased for use in production, due to wear and tear, changed market valuation and possibly market obsolescence. Thus, CFC represents a compensation for the loss of value of fixed assets to an enterprise.
According to the 2008 manual of the United Nations System of National Accounts
United Nations System of National Accounts
The United Nations System of National Accounts is an international standard system of national accounts, the first international standard being published in 1953...
,
CFC tends to increase as the asset gets older, even if the efficiency and rental remain constant to the end. The larger the depreciation write-off, the larger the gross income of a business. Consequently, business owners consider this accounting entry as very important; after all, it affects both their income, and their ability to invest.
Valuation
How much the depreciation charge actually will be, depends mainly on the depreciation rates which enterprises are officially permitted to charge for tax purposes (usually fixed by law), and on how fixed assets themselves are valued for accounting purposes. This makes the assessment of CFC quite complex, because fixed assets may be valued for instance at:- historic (acquisition) cost
- operating value (as part of a "going concern")
- accrual value
- current average sale-value in the market
- current replacement cost
- cash value
- economic value
- insured value
- scrap value
- deflated value (allowing for price inflation)
By how much then, do fixed assets used in production truly decline in value, within an accounting period? How should they be valued? This can be arguable and very difficult to answer, and in practice, various conventions are adopted by accountants and auditors within the framework of legal rules and economic theory.
In addition, the depreciation schedules imposed by tax departments may differ from the actual depreciation of business assets at market rates. Often, governments permit depreciation write-offs higher than true depreciation, to provide an incentive to enterprises for new investment. But this is not always the case; the tax rate might sometimes be lower than the real market-based rate. Furthermore, businesses might engage in creative accounting
Creative accounting
Creative accounting and earnings management are euphemisms referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules...
and deliberately state their assets and liabilities held at a balance date, or interpret the figures in some other way, to increase the amount of depreciation write-offs, and thus boost their income (how this is done will depend a lot on tax law).
For all these reasons, economists distinguish between different kinds of depreciation rates, arguing that the "true" consumption of fixed capital is really the economic depreciation, assessed by relating financial data to mathematical models, to arrive at a figure that "seems credible". The economic depreciation rate is based on observations of the average selling prices of assets at different ages. The economic depreciation rate is therefore a market-based depreciation rate, i.e. it is based on what an asset of a given age would currently sell for in the market.
Consumption of fixed capital in national accounts
In national accounts, CFC is a component of value addedValue added
In economics, the difference between the sale price and the production cost of a product is the value added per unit. Summing value added per unit over all units sold is total value added. Total value added is equivalent to Revenue less Outside Purchases...
or Gross Domestic Product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
, and regarded as a cost of production. It is defined in general terms as the decline, in an accounting period, of 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.
The UNSNA manual notes that "The consumption of fixed capital is one of the most important elements in the System... It may account for 10 per cent or more of total GDP." CFC is defined "in a way that is theoretically appropriate and relevant for purposes of economic analysis". Its value may therefore diverge considerably from depreciation actually recorded in business accounts, or as allowed for taxation purposes, especially if there is price inflation.
In principle, CFC is calculated using the actual or estimated prices and rentals of fixed assets prevailing at the time the production takes place, and not at the times fixed assets 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.
Unlike depreciation as calculated in business accounts, CFC in national accounts is, in principle, not a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods. Rather, fixed assets at a given moment in time are valued according to the remaining benefits derived from their use.
Depreciation charges in business accounts are adjusted in national accounts from historic costs to current prices, in conjunction with estimates of the capital stock.
Inclusions in CFC
In UNSNA, included are:- all tangible and intangible fixed assets owned by producers.
- fixed assets 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.
- Losses of fixed assets due to normal accidental damage, i.e. damage caused to assets used in production resulting from their exposure to the risk of fires, storms, accidents due to human errors, etc.
- interest costs incurred in acquiring fixed assets, which 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 thus measured by the actual or imputed rental on the asset, and not by depreciation alone. If the fixed asset is actually rented under an operating lease or similar contract, the rental is recorded under Intermediate consumptionIntermediate consumptionIntermediate consumption is an economic concept used in national accounts, such as the United Nations System of National Accounts , the US National Income and Product Accounts and the European System of Accounts .Conceptually, the aggregate "intermediate consumption" is equal to the amount of the...
as the purchase of a service produced by the lessor. If the user and the owner are one and the same unit, CFC is considered to represent only part of the cost of using the asset.
- Certain insurance premiums related to the acquisition or maintenance of fixed assets.
Exclusions from CFC
In UNSNA, excluded are:- the value of fixed assets destroyed by acts of war, or exceptional events such as major natural disasters, earthquakes, volcanic eruptions, tidal waves, exceptionally severe hurricanes, etc. (e.g. Hurricane KatrinaHurricane KatrinaHurricane Katrina of the 2005 Atlantic hurricane season was a powerful Atlantic hurricane. It is the costliest natural disaster, as well as one of the five deadliest hurricanes, in the history of the United States. Among recorded Atlantic hurricanes, it was the sixth strongest overall...
) which occur very infrequently.
- valuables (precious metals, precious stones, etc.)
- the depletion or degradation of non-produced assets such as land, mineral or other deposits, or coal, oil, or natural gas.
- losses due to unexpected technological developments that may significantly shorten the service lives of a group of existing fixed assets.
Gross and net capital stocks
In UNSNA, the value at current prices of the gross capital stock is obtained, by using price indices for fixed assets at current replacement cost, irrespective of the age of the assets.The net, or written-down value of a fixed capital asset is equal to its current replacement cost, less CFC accrued up to that point in time.
Criticism
The main criticism made of the way national accounts value CFC is that in trying to arrive at an "economic" concept and magnitude of depreciation, they arrive at figures which are at variance with the real world; even if the figures are argued to be "more realistic" from an economic point of view, they include and exclude portions of gross business income without making this explicit. The business income cited in the social account is not true business income, but a theoretical income which is derived from true business income.Thus, the criticism centres both on the valuation principles used, and the additional items included in the aggregate, which are not directly related to depreciation charges at all. Yet the whole computation strongly affects the size of the GDP figure and the aggregate profit figures provided. Because of the way CFC is calculated, aggregate profit (or operating surplus
Operating surplus
Operating surplus is an accounting concept used in national accounts statistics Operating surplus is an accounting concept used in national accounts statistics Operating surplus is an accounting concept used in national accounts statistics (such as United Nations System of National Accounts (UNSNA)...
the residual item in the product account) is likely to be understated, independently of the actual profit calculation, which is usually derived from tax data.
Ultimately, the distinction drawn between that portion of business operating expenditure included in CFC beyond depreciation, in contrast to that portion of operating expenditure included in Intermediate consumption
Intermediate consumption
Intermediate consumption is an economic concept used in national accounts, such as the United Nations System of National Accounts , the US National Income and Product Accounts and the European System of Accounts .Conceptually, the aggregate "intermediate consumption" is equal to the amount of the...
may appear rather capricious, rather than theoretically justified.
In Marxian economics
Marxian economics
Marxian economics refers to economic theories on the functioning of capitalism based on the works of Karl Marx. Adherents of Marxian economics, particularly in academia, distinguish it from Marxism as a political ideology and sociological theory, arguing that Marx's approach to understanding the...
, the official concept of CFC is also disputed, because it is argued that CFC really should refer to the value transferred by living labor from fixed assets to new output. Consequently, operating expenditures associated with fixed assets other than depreciation should be regarded as either as circulating constant capital
Constant capital
Constant capital , is a concept created by Karl Marx and used in Marxian political economy. It refers to one of the forms of capital invested in production, which contrasts with variable capital...
, faux frais of production
Faux frais of production
Faux frais of production is a concept used by classical political economists and by Karl Marx in his critique of political economy. It refers to "incidental operating expenses" incurred in the productive investment of capital, which do not themselves add new value to output...
or surplus value
Surplus value
Surplus value is a concept used famously by Karl Marx in his critique of political economy. Although Marx did not himself invent the term, he developed the concept...
, depending on the case. Furthermore, the measured difference between economic depreciation and actual depreciation charges will either add or lower the magnitude of total surplus value
Surplus value
Surplus value is a concept used famously by Karl Marx in his critique of political economy. Although Marx did not himself invent the term, he developed the concept...
.
See also
- DepreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
- Fixed capitalFixed capitalFixed capital is a concept in economics and accounting, first theoretically analysed in some depth by the economist David Ricardo. It refers to any kind of real or physical capital that is not used up in the production of a product and is contrasted with circulating capital such as raw materials,...
- Intermediate consumptionIntermediate consumptionIntermediate consumption is an economic concept used in national accounts, such as the United Nations System of National Accounts , the US National Income and Product Accounts and the European System of Accounts .Conceptually, the aggregate "intermediate consumption" is equal to the amount of the...
- Value addedValue addedIn economics, the difference between the sale price and the production cost of a product is the value added per unit. Summing value added per unit over all units sold is total value added. Total value added is equivalent to Revenue less Outside Purchases...
- Gross OutputGross OutputGross output is an economic concept used in national accounts such as the United Nations System of National Accounts and the US National Income and Product Accounts...
- Value productValue productThe value product is an economic concept formulated by Karl Marx in his critique of political economy during the 1860s, and used in Marxian social accounting theory for capitalist economies...
- United Nations System of National Accounts (UNSNA)