Depreciation is the permanent and coordinating diminution in the quality of quantity value of assets. Most individuals, at one time or another, purchase and trade in an automobile. The automobile dealer and the buyer typically discuss what the trade-in value of the old car is. Also, they may talk about the new car’s trade-in value in several years. In both cases, a decline in value is considered to be an example of depreciation.
Understand Depreciation
How Depreciation Works In Accounting?
To accountants, however, depreciation is not a matter of valuation. Rather, depreciations are a means of cost allocation. Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.
For example, a company like Goodyear (one of the world’s largest tire manufacturers) does not depreciate assets on the basis of a decline in their fair market value. Instead, it depreciates through systematic charges to expense.
This approach is employed because the value of the asset may fluctuate between the time the asset is purchased and the time it is sold or junked. Attempts to measure these interim value changes have not been successful because values are difficult to measure objectively.
Therefore, Goodyear charges the asset’s cost is charged to depreciation expense over its estimated life. It makes no attempt to value the asset at a fair market value between acquisition and disposition.
Companies use the cost allocation approach because it matches costs with revenues and because fluctuations in market value are uncertain and difficult to measure.
When companies write off the cost of long-lived assets over a number of periods, they typically use the term depreciation.
They use the term depletion to describe the reduction in the cost of natural resources (such as timber, gravel, oil, and coal) over period of time. The expiration of intangible assets, such as patents or copyrights, is called amortization.
Definition of Depreciation
Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the assets.
Depreciation is the process of allocating to expense the cost of assets over the accounting periods that benefit from the use of assets. Depreciation occurs as an asset is used to produce products of services.
Factors Involved in the Depreciation Process
Before establishing a pattern of charges to revenue, a company must answer three basic questions:
- What depreciable base is to be used for the asset?
- What is the asset’s useful life?
- What method of cost apportionment is best for this asset?
The answers to these questions involve combining several estimates into one single figure. Note the calculations assume perfect knowledge of the future, which is never attainable.
Depreciable Base for the Asset
The base established for depreciation is a function of two factors: the original cost and salvage or disposal value.
Salvage value is the estimated amount that a company will receive when it sells the asset or removes it from service. It is the amount to which a company writes down or depreciates the asset during its useful life. If an asset has a cost of $10,000 and a salvage value of $1,000, its depreciation base is $9,000.
| Original cost | $ 10,000 |
| Less: Salvage value | $ 1,000 |
| Depreciation base | $ 9,000 |
From a practical standpoint, companies often assign long-lived assets. However, they have substantial salvage values.
Estimation of Service Lives
The service life of an asset often differs from its physical life. A piece of machinery may be physically capable of producing a given product for many years beyond its service life.
However a company may not use the equipment for all that time because the cost of producing the product in later years may be too high.
For example, the old Slater cotton mill in Pawtucket, Rhode Island, is preserved in remarkable physical condition as a historic landmark in U.S. industrial development, although its service life was terminated many years ago.
Companies retire assets for two reasons: physical factors (such as casualty or expiration of physical life) and economic factors (obsolescence).
Physical factors are the wear and tear, decay, and casualties that make it difficult for the asset to perforin indefinitely. These physical factors set the outside limit for the service life of an asset.
We can classify the economic or functional factors into three categories:
- Inadequacy results when an asset ceases to be useful to a company because the demands of the firm have changed. An example would be the need for a larger building to handle increased production. Although the old building may still be sound, it may have become inadequate for the company’s purpose.
- Supersession is the replacement of one asset with another more efficient and economical asset. Examples would be the replacement of the mainframe computer with a PC network or the replacement of the Boeing 767 with the Boeing 777.
- Obsolescence is the catchall for situations not involving inadequacy and supersession. Because the distinction between these categories appears artificial, it is probably best to consider economic factors collectively instead of trying to make distinctions that are not clear-cut.
To illustrate the concepts of physical and economic factors, consider a new nuclear power plant.
Which is more important in determining the useful life of a nuclear power plant—physical factors or economic factors?
The limiting factors seem to be;
- ecological considerations,
- competition from other power sources, and
- safety concerns.
Physical life does not appear to be the primary factor affecting useful life. Although the plant’s physical life may be far from over, the plant may become obsolete in 10 years.
For a house, physical factors undoubtedly are more important than the economic or functional factors relative to useful life.
Whenever the physical nature of the asset primarily determines useful life, maintenance plays an extremely vital role. The better the maintenance, the longer the life of the asset.
In most cases, a company estimates the useful life of an asset based on its past experience with the same or similar assets.
Others use sophisticated statistical methods to establish a useful life for accounting purposes. And in some cases, companies select arbitrary service lives.
In a highly industrial economy such as that of the United States, where research and innovation are so prominent, technological factors have as much effect, if not more, on service lives of tangible plant assets as physical factors do.
Factors in Computing Depreciation
Three Factors are relevant in determining Depreciation –
- Cost.
- Salvage value/resident value.
- Useful life.
Costs
The cost of the asset consists of all necessary and reasonable expenditures to acquire it and to repair the asset for its intended use.
Salvage/residential value
Salvage value is an estimate of the asset’s value at the end of its benefit period.
Useful life
Useful life is the length of time of assets that will be used in the operations of a business.
Causes of Depreciation
There are some causes of depreciation as follows-
- Physical deterioration: Physical deterioration results from the use of the assets.
- Inadequacy: The inadequacy of an asset is its inability to produce enough products or provide enough service to meet current demands.
- Obsolescence: An asset’s obsolescence is its usefulness decline brought about by inventions and technological progress.
- Wear and tear: Most of tangible assets are decayed for day-to-day use. Example-Cars, Equipments. Furniture etc.
- Time passing: The assets of definite periods such as ease equity, copyright, patent, etc., are depreciated as time passes.
- Direct consumption: Natural assets such as coal, iron, oil, gas, etc. are decreasing for exertion, so they are certainly depreciated.
- Permanent fall in market price: If the market value of Share security, bonds, and debentures falls than it is treated as depreciation.
- Price fall due to accident: For accident. Equipment can be depreciated fixedly.
Features of Depreciation
There are some features of depreciation as follows-
- Non-Cash expense: Depreciation is an expense, but it is not like the valuation of expenses such as salary, advertising, rent etc.
- Estimated expense: Other expenses of business are real values where as depreciation is estimated expenses and lelative values.
- Elements of depreciation: The value of depreciation depends on three elements-(i) Cost of assets (ii) Residual value (iii) Useful life.
Depreciation Methods
There are many depreciation methods for allocating an asset’s cost over the accounting periods in its useful life. The most frequently used methods of depreciation are:
- Straight-Line Method
- Activity Method:
- Units-of-production method.
- Working hour’s method.
- Decreasing Charge Method (Accelerated):
- Sum-of-the-years digits method (SYD).
- Declining balance method
- Double declining balance method.
- Special Depreciation Method:
- Group and composite method.
- Hybrid or combination method.
Straight-Line method
The straight-tine depreciation charges the same amount to expense for each period of the assets’ useful life. The depreciation is computed from the following formula;
Straight-line depreciation = (Cost – Salvage Value) / Estimated Useful Life
The straight-line method charges an equal share to each period. But the productivity of the use of some assets differs from one accounting period to another accounting period.
When the use of equipment varies from period to period, the activity (units of production/working hour’s depreciation method) can provide a better making of expenses with revenues than straight-line depreciation.
Activity Method
Under this method, depreciation charges amount to expense for each period of an asset’s useful life depending on its usage.
The activity method (also called the variable-charge or units-of-production approach) assumes that depreciation is a function of use or productivity, instead of the passage of time.
A company considers the life of the asset in terms of either the output it provides (units it produces) or an input measure such as the number of hours it works.
Conceptually, the proper cost association relies on output instead of hours used, but often the output is not easily measurable.
In such cases, an input measure such as machine hours is a more appropriate method of measuring the dollar amount of depreciation charges for a given accounting period. The crane poses no particular depreciation problem.
Stanley can measure the usage (hours) relatively easily. If SUpley uses the crane for 4,000 hours the first year, the depreciation charge is:
| Depreciation Charge = { (Cost less salvage) x Hours this year } / Total estimated hours = { ($500,000 – $50,000 ) x 4,000} / 30,000 = 60,000 |
The major objection to the straight-line method is that it rests on two tenuous assumptions:
- The asset’s economic usefulness is the same each year, and
- the repair and maintenance expense is essentially the same each period.
One additional problem that occurs in using straight-line—as well as some others—is that distortions in the rate of return analysis (income/assets) develop.
The illustration below indicates how the rate of return increases, given constant revenue flows, because the asset’s book value decreases.
| Year | Depreciation Expense $ | Undercoated Asset Balance (book value) $ | Income (after depreciation expense) $ | Rate of Return (Income + Assets) $ |
| 0 | – | 500,000 | – | – |
| 1 | 90,000 | 410,000 | $100,000 | 24.4% |
| 2 | 90,000 | 320,000 | 100,000 | 31.2% |
| 3 | 90,000 | 230,000 | 100,000 | 43.5% |
| 4 | 90,000 | 140,000 | 100,000 | 71.4% |
| 5 | 90,000 | 50,000 | 100,000 | 200.0% |
Types of activity method;
- Units-of-production method.
- Working hour’s method.
Units-of-production method
Units of production method assign an equal amount of depreciation for each unit of product manufactured or service rendered by and ln this method depreciation charges amount to expense tor each period of an asset’s useful life depending on its total production units. Under this method depreciation is calculated from the following formula:
Depreciation Expense = (Cost – Salvage value) x No.of’ units Pr ouce this year /Total units production
Working hours/ machine hour’s method
Under this method, depreciation charges amount to expense for each period of an asset’s useful life depending of its total working hours. In this method, depreciation is calculated from the following formula;
Depreciation Expense = (Cost – Salvage value) x Working hours in this period Total working hours of asset
Decreasing (Accelerated) Charge Method
Under this method provide for a higher depreciation expense in the earlier years and lower in later periods. 1 he main justification for this approach is that the asset suffers the greatest loss of services in those years.
The decreasing-charge methods provide for a higher depreciation cost in the earlier years and lower charges in later periods. Because these methods allow for higher early-year charges than in the straight-line method, they are often called accelerated depreciation methods.
What is the main justification for this approach? The rationale is that companies should charge more depreciation in earlier years because the asset is most productive in its earlier years.
Furthermore, the accelerated methods provide constant cost because the depreciation charge is lower in the later periods, at the time when the repair and maintenance costs are often higher.
Generally, companies use one of two decreasing-charge methods: the sum-of-the-years’-digits method, or the declining-balance method.
Sum-of-the years digits method(SYD)
The sum-of-the-years’-digits method results in a decreasing depreciation charge based on decreasing traction of depreciable cost (original costless salvage value). Each fraction uses the sum of the years as a denominator (5+4+3+2+l”l 5).
The numerator is the number of years of estimated life remaining as of the beginning of the year. In this method, the numerator decreases year by year, and the denominator remains constant (5/15, 4/15, 3/15, 2/15, and 1/15).
At the end of the asset’s useful life, the balance remaining should equal the salvage value.
The illustration below shows this method of computation.
| Year | Depreciation Base | Remaining Life in Years | Depreciation Fraction | Depreciation Expense | book value, End of Year |
|---|---|---|---|---|---|
| 1 | 450,000 | 5 | 5/15 | 150,000 | 350,000 |
| 2 | 450,000 | 4 | 4/15 | 120,000 | 230,000 |
| 3 | 450,000 | 3 | 3/15 | 90,000 | 140,000 |
| 4 | 450,000 | 2 | 2/15 | 60,000 | 80,000 |
| 5 | 450,000 | 1 | 1/15 | 30,000 | 50,000 (Salvage value) |
| 15 | 15/15 | 450,000 |
Under this method result in a decreasing depreciation charge based on a decreasing function, of depreciable cost.
Each function uses the sum of the years as a denominator (5+4+3+2+1=15) or digits / denomination = and the number of years of estimated life remaining as of the beginning of the years as a numerator. In this method, the numerator decreases year by year and the denominator remains constant (5/15. 4/15. 3/15. 2/15. 1/15).
At the end of assets useful life, the balance remaining should be equal to the salvage value.
Depreciation Expenses = (Cost-Salvagevalue) x (Numerator / Digits)
- 1 year depreciation = (Cost – salvage value) x 5/15
- 2nd year depreciation = (Cost – salvage value) x 4/15
- 3 year depreciation = (Cost – salvage value) x 3/15
- 4th year depreciation = (Cost – salvage value) x 2/15
- 5th year depreciation = (Cost – salvage value) x 1/15
Declining-Balance Method
The declining balance method utilization depreciation rate expressed as a percentage that is some multiple of the state line method.
For example, the double-declining rate of 10-year assets is 20% double the straight-line rate which is 10%. The company applied a constant rate to the declining book value each year.
Unlike other methods, the declining balance method does not deduct the salvage value in computing the depreciation base.
The declining balance rate is multiplied by the book value of the asset at the beginning of each period.since the depreciation charged reduces the book value of the acid is applying the constant declining balance method to a successively lower book value results in lower depreciation charges each year.
This process continues until the book value of the asset equals its estimates estimated salvage value.
At that time the company discontinues depreciation.
Company various multiples of in practice. For example, the double-declining balance method depreciates acid at twice (200%) the straight-line rate.
Let’s look at the table below to understand the depreciation charges if we are using a double-declining approach.
| Year | Book Value of Asset First of Year $ | Rate on Balance $ | Depreciation Expense $ | Balance Accumulated Depreciation $ | Book Value, End of Year $ |
|---|---|---|---|---|---|
| 1 | 500,000 | 40% | 200,000 | 200,000 | 300,000 |
| 2 | 300,000 | 40% | 120,000 | 320,000 | 180,000 |
| 3 | 180,000 | 40% | 72,000 | 392,000 | 108,000 |
| 4 | 108,000 | 40% | 43,200 | 435,200 | 64,800 |
| 5 | 64,800 | 40% | 14,800 Limited to $14,800 because book value should not be less than salvage value. | 450,000 | 50,000 |
| Based on twice the straight-line rate of 20% ($90,000/ $450,000 = 20%; 20% x 2 = 40%) | |||||
Companies often switch from the declining balance method to the straight-line method near the end of the acids useful life to ensure that they depreciate the asset only to its salvage value.
The declining method of depreciation uses straight-line depreciation rate and applies it to the book value of the asset at the beginning of each period. Since the book value declines each period, the amount of depreciation also declines each period
A common depreciation rate is twice the straight-line rate. This method is called the double-declining balance method. This method is applied as follows;
- Compute the straight-line depreciation rate;
- double it, and
- Compute depreciation expense by applying this rate to the asset’s book value at the beginning of the period.
This method of depreciation is calculated in the following way –
- Step #1: Straight-line ratc= 100% / Useful life = 100% / 10 years=10%
- Step #2: Depreciation expense = (Book value at beginning period x Straight line rate); Or Double – declining – balance rale = (Straight line rate x 2)
- Step #3: Depreciation expense = (Book value at beginning period x Double declining balance rate)
Special Depreciation Method
Sometimes companies adopt special depreciation methods. Reasons for doing so might be that a company’s assets have unique characteristics or the nature of the industry. Two of these special methods are;
- Group and composite method.
- Hybrid or combination method.
Group and composite method
The term Group refers to a collection of assets that are similar in nature; “Composite” refers to a collection of assets that are dissimilar in nature. The group method is frequently used when the assets are fairly homogeneous and have approximately the same useful life; the composite approval is used when the assets are heterogeneous and have a different useful life.
Companies often depreciate multiple-asset accounts using one rate. For example, AT&T might depreciate telephone poles, microwave systems, or switchboards by groups.
Two methods of depreciating multiple-asset accounts exist: the group method and the composite method. The choice of method depends on the nature of the assets involved.
A pure form of the declining-balance method (sometimes appropriately called the “fixed percentage of book value method”) has also been suggested as a possibility. This approach finds a rate that depreciates the asset exactly to salvage value at the end of its expected useful life.
The formula for determination of this rate is as follows:
Life in years is n. After computing the depreciation rate, a company applies it to the declining book value of the asset from period to period, which means that depreciation expense will be successively lower.
This method is not used extensively in practice due to cumbersome computations. Further, it is not permitted for tax purposes.
Companies frequently use the group method when the assets are similar in nature and have approximately the same useful lives. They use the composite approach when the assets are dissimilar and have different lives.
The group method more closely approximates a single-unit cost procedure because the dispersion from the average is not as great.
The computation for group or composite methods is essentially the same: find an average and depreciate on that basis. Companies determine the composite depreciation rate by dividing the depreciation per year by the total cost of the assets.
To illustrate, X-Motors establishes the composite depreciation rate for its fleet of cars, trucks, and campers as shown in Illustration below.
| Asset | Original Cost $ | Residual Value $ | Deprecietten Cost $ | Estimated Life (years) $ | Depreciation per Year (straight-line) $ |
|---|---|---|---|---|---|
| Cars | 145,000 | 25,000 | 120,000 | 3 | 40,000 |
| Trucks | 44,000 | 4,000 | 40,000 | 4 | 10,000 |
| Campers | 35,000 | 5,000 | 30,000 | 5 | 6,000 |
| 224,000 | 34,000 | 190,000 | 56,000 | ||
Composite depreciation rate = ($56,000 / $224000) = 25%Composite life = 3.39 years ($190,000 + $56,000) | |||||
If there are no changes in the asset account, X-Motors will depreciate the group of assets to the residual or salvage value at the rate of $56,000 ($224,000 x 25%) a year.
As a result, it will take X-Motors 3.39 years to depreciate these assets. The length of time it takes a company to depreciate its assets on a composite basis is called the composite life.
We can highlight the differences between the group or composite method and the single-unit depreciation method by looking at asset retirements.
If X-Motors retires an asset before or after the average service life of the group is reached, it buries the resulting gain or loss in the Accumulated Depreciation account.
This practice is justified because X-Motors will retire some assets before the average service life and others after the average life.
For this reason, the debit to Accumulated Depreciation is the difference between the original cost and cash received. X-Motors does not record a gain or loss on disposition.
To illustrate, suppose that X-Motors sold one of the campers at a cost of $5,000 for $2.600 at the end of the third year. The entry is:
| Accumulated Depreciation | 2,400 | |
| Cash | 2,600 | |
| Cars, Trucks, and Campers | 5,000 |
If X-Motors purchases a new type of asset (mopeds, for example), it must compute a new depreciation rate and apply this rate in subsequent periods.
The group or composite method simplifies the bookkeeping process and tends to average out errors caused by over or under-depreciation. As a result, gains or losses on disposals of assets do not distort periodic income.
On the other hand, the unit method has several advantages over the group or composite methods;
- It simplifies the computation mathematically.
- It identifies gains and losses on disposal.
- It isolates depreciation on idle equipment.
- It represents the best estimate of the depreciation of each asset, not the result of averaging the cost over a longer period of time.
As a consequence, companies generally use the unit method. Unless stated otherwise, you should use the unit method in homework problems.
Hybrid or Combination method
A hybrid or combination method widely used in the steel industry is a combination straight-line/activity approach referred to as the production variable method.
In addition to the depreciation methods already discussed, companies are free to develop their own special or tailor-made depreciation methods.
GAAP requires only that the method results in the allocation of an asset’s cost over the asset’s life in a systematic and rational manner.
For example, the steel industry widely uses a hybrid depreciation method, called the production variable method that is a combination straight line/activity approach.
Special Depreciation Issues
We still need to discuss several special issues related to depreciation:
- How should companies compute depreciation for partial periods?
- Does depreciation provide for the replacement of assets?
- How should companies handle revisions in depreciation rates?
Depreciation and Partial Periods
Companies seldom purchase plant assets on the first day of a fiscal period or dispose of them on the last day of a fiscal period. A practical question is: How much depreciation should a company charge for the partial periods involved?
In computing depreciation expense for partial periods, companies must determine the depreciation expense for the full year and then prorate this depreciation expense between the two periods involved. This process should continue throughout the useful life of the asset.
Assume, for example, that Steeltex Company purchased an automated drill machine with a 5-year life for $45,000 (no salvage value) on June 10, 2009.
The company’s fiscal year ends December 31. Steeltex, therefore, charges depreciation for only 62/3 months during that year.
The total depreciation for a full year (assuming straight-line depreciation) is $9,000 ($45,000/5).
The partial-period calculation is relatively simple when Steeltex uses straight-line depreciation.
But how is partial-period depreciation handled when it uses an accelerated method such as sum-of-the-years’-digits or double-declining-balance?
As an illustration, assume that Steeltex purchased another machine for $10,000 on July I, 2009, with an estimated useful life of five years and no salvage value. The illustration below shows the depreciation figures for 2009, 2010, and 2011.
Sum-of-the-Years Digits | ||
| 1st full year | 5/15 x 10,000 | 3,333.33 |
| 2nd full year | 4/15 x 10,000 | 2,666.67 |
| 3rd full year | 3/15 x 10,000 | 2,000.00 |
| Double-Declining-Balance | |
| (40% x$10,000) = | $4,000 |
| (40% x6,000) = | 2,400 |
| (40% x3,600) = | 1,440 |
| Depreciation from July 1, 2009, to December 31, 2009 | |
| 6/12 x 3,333 = $1.666.67 | 6/12 x 4,000 = $2,000 |
Depreciation for 2010 | |||
| 6/12 x 3,333.33 | 1,666.67 | 6/12 x 4,000 | 2,000 |
| 6/12 x 2,666.67 | 1,333.33 | 6/12 x 2,400 | 1,200 |
| 3.000.00 | 3.200 | ||
| or ($10,000 – $2,000) x 40% = $3,200 | |||
| Depreciation for 2011 | |||
| 6/12 $2,666.67 | 1,333.33 | 6/12 x 2,400 | $1,200 |
| 6/12 x 2,000.00 | 1,000.00 | 6/12 x 1,440 | 720 |
| $2.333.33 | $1,920 | ||
| or; ($10,000 – $5,200) x 40% = $1,920 | |||
Sometimes a company like Steeltex modifies the process of allocating costs to a partial period to handle acquisitions and disposals of plant assets more simply.
One variation is to take no depreciation in the year of acquisition and a full year’s depreciation in the year of disposal.
Other variations charge one-half year’s depreciation both in the year of acquisition and in the year of disposal (referred to as the half-year convention) or charge a full year in the year of acquisition and none in the year of disposal.
In fact, Steeltex may adopt any one of these several fractional-year policies in allocating cost to the first and last years of an asset’s life so long as it applies the method consistently.
However, unless otherwise stipulated, companies normally compute depreciation on the basis of the nearest full month.
The table below shows depreciation allocated under five different fractional-year policies using the straight-line method on the $45.000 automated drill machine purchased by Steeltex Company on June 10. 2009. discussed earlier.
| Machine Cost – $45.000 |
Depreciation Allocated per Period Over 5-Year Life | |||||
| Fractional Year Policy | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 |
| 1. Nearest fraction of a year. | 5,000 | 9,000 | 9,000 | 9,000 | 9,000 | 4,000 |
| 2. The nearest full month. | 5,250 | 9,000 | 9,000 | 9,000 | 9,000 | 3,750 |
| 3. Half-year in the period of acquisition and disposal. | 4,500 | 9.000 | 9,000 | 9,000 | 9,000 | 4,500 |
| 4. Full-year in the period of acquisition, none in the period of disposal. | 9.000 | 9,000 | 9,000 | 9,000 | 9,000 | -0- |
| 5. None in the period of acquisition, full-year in the period of disposal. | -0- | 9,000 | 9,000 | 9,000 | 9,000 | 9,000 |
Depreciation and Replacement of Fixed Assets
A common misconception about depreciation is that it provides funds for the replacement of fixed assets. Depreciation is like other expenses in that it reduces net income. It differs, though, in that it does not invoke a current cash outflow.
To illustrate why depreciation does not provide funds for replacement of plant assets, assume that a business starts operating with plant assets of $500,000 that nave a useful life of five years.
The company’s balance sheet at the beginning of the period is:
This extreme example illustrates that depreciation in no way provides funds for the replacement of assets. The funds for the replacement of the assets come from the revenues (generated through, use of the asset).
Without the revenues, no income materializes and no cash inflow results.
Revision of Depreciation Rales
When purchasing a plant asset, companies carefully determine depreciation rates based on past experience with similar assets and other pertinent information.
The provisions for depreciation are only estimates, however. They may need to revise them during the life of the asset.
Unexpected physical deterioration or unforeseen obsolescence may decrease the estimated useful life of the asset.
Improved maintenance procedures, revision of operating procedures, or similar developments may prolong the life of the asset beyond the expected period.
For example, assume that International Paper Co. purchased machinery with an original cost of $90,000. It estimates a 20-year life with no salvage value.
However, during year 11, International Paper estimates that it will use the machine for an additional 20 years. Its total life, therefore, will be 30 years instead of 20.
Depreciation has been recorded at the rate of 1/20 of $90.000, or $4,500 per year by the straight-line method. On the basis of a 30-year life, international Paper should have recorded depreciation as 1/30 of $90,000, or $3,000.per year.
It has therefore overstated depreciation, and understated net income, by $1,500 for each of the past 10 years, or a total amount of $15,000. The illustration below shows this computation.
| Per Year | For 10 Years | |
| Depreciation charged per books (1/20 x $90,000) | 4,500 | 45,000 |
| Depreciation based on a 30-year life (1/30 x $90,000) | 3,000 | 30,000 |
| Excess depreciation charged | 1,500 | 15.000 |
International Paper should report this change in estimate in the current and prospective periods. It should not make any changes in previously reported results.
And it does not adjust opening balances nor attempt to “catch up” for prior periods. The reason?
Changes in estimates are a continual and inherent part of any estimation process. Continual restatement of prior periods would occur for revisions of estimates unless handled prospectively.
Therefore, no entry is made at the time the change in estimate occurs.
Charges for depreciation in subsequent periods (assuming the use of the straight-line method) are determined by dividing the remaining book value less any salvage value by the remaining estimated life.
| Machinery | 90,0.00 | ||
| Less: Accumulated depreciation | 45,000 | ||
| Book value of machinery at the end of 10th year | 45,000 | ||
| Depreciation (future periods) = $45,000 book value + 20 years remaining life = $2,250 The entry to record depreciation for each of the remaining 20 years is: | |||
| Depreciation Expense | 2,250 | ||
| Accumulated Depreciation—Machinery | 2,250 | ||
Selecting a Depreciation Method
Which depreciation method should be selected? Which method is best for matching revenues and expenses it should be used.
For example, if revenues generated by the assets are constant over the asset’s useful life, straight-line depreciation is employed. On the other hand, if revenue is higher or lower at the beginning, the decreasing change method (accelerated) of depreciation is employed.
Many companies use the straight-line method for book purposes and use the accelerated depreciation method for tax purposes. This provides the best of both methods: a lower tax and a higher net income for financial reporting purposes.
Real estate companies use lower depreciation at the beginning and higher depreciation at the end because real estate is highly debt financial. So, higher total assets and net income were reported in the earlier years of the project.
Conclusion: Depreciation is a process of allocation cost, not of valuation
To summarize, the selection of a depreciation method involves factors such as the nature and uncertainty of revenue flows, matching costs and revenue, effect on income and assets values, tax consideration, and record-keeping costs.
Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. Here, the depreciable amount is the difference between cost and scrap value. This amount is not charged to expenses in the purchasing year but is allocated in the years the asset earns benefits.
But valuation means the value of the asset is revalued in the market price year to year. So we agree that “Depreciation is a process of allocation cost, not of valuation.”
