Depreciation and changes in estimates and method
Because of the estimates and judgments involved in computing depreciation (as well as amortization and depletion), it is inevitable that facts in subsequent years will show that some of the original projections and assumptions were incorrect.
Changes in service life
If the originally selected service life of an asset turns out to be sufficiently incorrect that future years’ reported income will be materially misstated, GAAP call for the firm to account for the correction as a change in estimate. To avoid manipulations, the GAAP call for the book value (adjusted for salvage) remaining at the date of the change to be spread over the revised estimated life of the asset.
For example, assume that this asset was purchased on January 4, 20×1, and was being depreciated on a straight-line basis:
During 20×3, it was determined that the asset would be sold for $20,000 at the end of 20×4 instead of the end of 20×5. The book value as of the end of 20×2 effectively becomes the new cost of the asset, and the new service life is two years. The depreciation expense for 20×3 and 20×4 is found as follows:
The Following example shows the annual depreciation charges over the asset’s four-year life.
Annual depreciation expense when life is shortened to four years beginning with 20×3
Below example shows the amounts that would have been recorded if the life was extended during 20×3 until the end of 20×7. The revised annual charge ($12,600) is found by dividing the number of years in the new life (five years) into the remaining depreciable basis ($63,000).
Annual depreciation expense when life is extended to seven years beginning with 20×3
If a declining balance method was being used, a new rate would be computed for the remaining life by multiplying the new straight-line rate by the appropriate multiplier (1.25, 1.50, or 2.00). If the sum of the years’ digits was being applied, a new denominator would be computed as the sum of the digits from one to the number of years in the revised life. The numerator would start again at that same number.
Changes in salvage value
If the original estimated salvage value is discovered to be sufficiently in error as to cause the financial statements to be materially misleading, the firm should prepare a prospectively revised depreciation schedule with the new salvage value being deducted from the book value of the asset. Suppose that the salvage value of the asset described above is reduced to in 20×3; these results would be achieved:
Thus, the charge for each of the remaining three years would be $25,000.
Change in method
If the firm’s management decides to change its choice of depreciation method, the change is considered to be more substantive and the accounting procedure is somewhat more complex.
In order to avoid the complexities, many firms adopt an incremental approach to changing the method. That is, assets acquired after the change are depreciated under the new method while the old assets are depreciated under the old method. A note such as this one may be used to disclose the change:
Property additions subsequent to October 1, 20×1, are depreciated by the straight line method. Property acquired prior to that date is depreciated by the declining balance method. The effect of this change was to increase net income and net income per share by $850,000 and 75 cents.
This approach is acceptable even though it violates consistency in reporting. In order to be more thorough, many companies make a comprehensive change, in which depreciation on old assets is computed under the new method.