When seeking to determine how much depreciation to assign to given periods, accountants should select a depreciation method that mirrors the pattern of the loss of the asset’s usefulness.
The chosen method should allocate the asset’s cost as equitably as possible to the periods during which services are obtained from its use. The method produces a cost allocation in a systematic and rational manner.
In this case, “systematic” means that the amount in any given year can be computed objectively and verifiably. “Rational” means that there is a relationship between the amount of depreciation in the period and the amount of usefulness expected to be lost.
Ideally, the expense should be associated with the period in which the firm earns revenue from using the asset. Furthermore, the amount of expense in the year should be proportional to the amount of revenue that is realized.
The most straightforward interpretation of this ideal is allocation on the basis of units of output produced in a given period. If that procedure is not feasible, it can be approximated by units of input (e.g., hours of operation).
If that measure is not feasible, it can be approximated by allocating cost according to the passage of time. Also, there may be no real connection between the amount an asset is used and the amount of value lost through use.
For example, technological changes occur just as rapidly even if the item is not used. In these situations, the ideal allocation is based on the passage of time.
For these two reasons, the vast majority of depreciation methods are based on time.
The current methods of depreciation for operating assets that are in use are the following:
- Units of production depreciation
- Straight line
- Accelerated (sum-of-the-years’ digits and declining balance)
- Interest (annuity and sinking fund)
Selecting a Depreciation Method
Ideally, the selection of depreciation methods to apply to a firm’s assets should be based on achieving the best financial representation of reality.
However, that goal cannot be achieved because it is impossible to establish a mutually agreeable concept of what constitutes “reality.” Consequently, the decision must be based on other factors.
Among the most influential factors is the need for consistency. A firm should be consistent in selecting methods for depreciating similar assets. Many firms simply use the same method for all assets or they choose a method widely used in the industry.
Conservatism is often a factor in the selection of not only depreciation methods but also estimated lives and salvage values. There may be a tendency to make choices that produce higher periodic expenses in order to avoid overstating earnings.
However, it is just as theoretically unsound to artificially understate earnings.
Furthermore, if the assets are used beyond artificially short service lives, reported annual income is higher in years after the selected service life has expired than it would be under a more appropriate choice.
The income tax regulations allow firms to use different approaches to computing depreciation on their tax returns and financial statements.
Further, the law allows accelerated depreciation to be used in virtually all situations, as well as arbitrarily short service lives and low salvage values.
Consequently, depreciation policies selected for use in the tax return often produce unsuitable measures for the income statement. Despite this, some managers use the same figures for both purposes to avoid the cost of maintaining two sets of records.
If an operating asset is used in manufacturing products, its depreciation for the period should be debited to the Manufacturing Overhead account and then allocated to the appropriate inventory accounts.
If used in some other way, the debit should be recorded in the Depreciation Expense account. The credit in any case should be recorded in a contra account, preferably entitled Accumulated Depreciation.
This approach allows the statement reader to make a rough judgment as to the likelihood of the replacement of the assets and its potential effect on solvency.