Accounting: The Language of Business (Part 59)

“Behind every good businessman there is a great accountant.” —Unknown

Fixed Assets and Intangible Assets (Part C)

by

Charles Lamson

Units-of-Production Method

How would you depreciate a fixed asset when its service is related to use rather than time? When the amount of use of a fixed asset varies from year to year, the units-of-production method is more appropriate than the straight-line method. In such cases, the units-of-production method better matches the depreciation expense with the related revenue.

The units-of-production method provides for the same amount of depreciation expense for each unit produced or each unit of capacity used by the asset. To apply this method, the useful life of the asset is expressed in terms of units of productive capacity such as hours or miles. The total depreciation expense for each accounting period is then determined by multiplying the unit depreciation by the number of units produced or used during the period. For example, assume that a machine with a cost of $24,000 and an estimated residual value of $2,000 is expected to have an estimated life of 10,000 operating hours. The depreciation for a unit of 1 hour is computed as follows:

$24,000 cost - $2,000 estimated residual value / 10,000 estimated hours = $2.20 hourly depreciation

Assuming that the machine was in operation for 2,100 hours during a year, the depreciation for that year would be $4,620 ($2.20 * 2,100 hours).

Declining-Balance Method

The declining-balance method provides for a declining periodic expense over the estimated useful life of the asset. To apply this method, the annual straight-line depreciation rate is doubled. For example, the declining balance rate for an asset with an estimated life of 5 years is 40%, which is double the straight-line rate of 20% (100% / 5).

For the first year of use, the cost of the asset is multiplied by the declining balance rate. After the first year, the declining book value (cost minus accumulated depreciation) of the asset is multiplied by this rate. To illustrate, the annual declining balance depreciation for an asset with an estimated 5-year life and a cost of $24,000 is shown below.

You should know that when the declining balance method is used, the estimated residual value is not considered in determining the depreciation rate. It is also ignored in computing the periodic depreciation. However, the asset should not be depreciated below its estimated residual value. In the above example, the estimated residual value was $2,000. Therefore, the depreciation for the fifth year is $1,110.40 ($3,110.40 - $2,000) instead of $1,244.16 (40% * $3,110.40).

In the example above, we assumed that the first use of the asset occurred at the beginning of the fiscal year. This is normally not the case in practice, however, and depreciation for the first partial year of use must be computed. For example, assume that the asset above was in service at the end of the third month of the fiscal year. In this case, only a portion (9 / 12) of the first bold years depreciation of $9,600 is allocated to the first fiscal year. Thus, depreciation of $7,200 (9 / 12 * $9,600) is allocated to the first partial year of use. The depreciation for the second fiscal year would then be $6,720 [40% x ($24,000 - $7,200)].

Comparing Depreciation Methods

The straight-line method provides for the same periodic amount of depreciation expense over the life of the asset. The units-of-production method provides for periodic amount of depreciation expense that vary, depending upon the amount the asset is used.

The declining-balance method provides for a higher depreciation amount in the first year of the asset's use, followed by a gradually declining amount. For this reason, the declining balance method is called an accelerated depreciation method. It is most appropriate when the decline in an asset's productivity or earning power is greater in the early years of its use than in later years. Further, using this method is often justified because repairs tend to increase with the age of an asset. The reduced amount of depreciation in later years are thus offset to some extent by increased repair expenses.

The periodic depreciation amounts for the straight-line method and the declining-balance method are compared in Exhibit 6. This comparison is based on an asset cost of $24,000, an estimated life of 5 years, and an estimated residual value of $2,000. 

EXHIBIT 6 Comparing Depreciation Methods

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST, PP. 399-400*

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