Depreciation methods and estimate revisions

Learning goals

• Calculate straight-line, diminishing-balance, and units-of-production depreciation.
• Choose a method that reflects the expected consumption pattern.
• revise useful life and residual value prospectively.
• Compare method effects on profit and carrying amount.

Prerequisite check

Depreciable amount is generally cost − residual value. Depreciation is allocation, not a direct attempt to show market value or to save cash for replacement.

Vocabulary

• Useful life: period or output over which the asset is expected to be used.
• Residual value: expected disposal amount at the end of useful life, net as defined by policy.
• Straight-line: equal depreciation per unit of time.
• Diminishing balance: constant rate applied to opening carrying amount.
• Units of production: depreciation based on actual output or usage.
• Prospective revision: new estimate applied now and in future, without restating past estimates.

Core idea

The method should reflect how benefits are consumed. Estimates are reviewed when new evidence arises. A reasonable estimate that later changes is revised prospectively; it is not automatically an error.

Why this treatment makes sense

Equal annual use supports straight-line; heavier early consumption may support a diminishing method; machine hours or units may best represent production equipment. Using current evidence for remaining depreciation keeps the carrying amount and future expense aligned without pretending earlier knowledge existed.

A repeatable method

1. Confirm cost, in-service date, residual value, and useful life/output.
2. Select the method that fits consumption, not the method that produces desired profit.
3. Calculate current depreciation and cap it so carrying amount does not fall below residual value.
4. Record debit Depreciation Expense; credit Accumulated Depreciation.
5. For a revision, calculate current carrying amount first.
6. Spread carrying amount − revised residual over revised remaining life or output.

Worked example

A machine costs $90,000, has $6,000 residual value, a seven-year life, and expected production of 120,000 units. First-year production is 18,000 units.

Table: First-year comparison of depreciation methods

Under straight-line, the entry is debit Depreciation Expense—Machinery $12,000; credit Accumulated Depreciation—Machinery $12,000.

After two straight-line years, carrying amount is $66,000. New evidence indicates a $3,000 residual value and three remaining years. Revised annual depreciation is ($66,000 − $3,000) ÷ 3 = $21,000 beginning in year 3. The prior $24,000 is not restated.

Journal, ledger, and statement connection

Cost stays in Machinery at $90,000; accumulated depreciation grows. The statement of financial position nets the two to carrying amount. Depreciation expense lowers profit and retained earnings but is added back in the indirect operating cash-flow reconciliation because it did not use current-period cash.

Common mistakes

• Subtracting accumulated depreciation from cost and also reducing the asset account each year.
• Applying a diminishing rate to original cost every year.
• Using residual value twice in a units-of-production calculation.
• Restating earlier years for a genuine estimate change.
• Depreciating land, which normally has no finite useful life, without a separable depreciable component.

Guided practice

Equipment costs $44,000, residual value $4,000, life five years. Straight-line depreciation is $8,000 a year. If purchased and available for use October 1 and the policy uses monthly proration, first-year depreciation is $8,000 × 3/12 = $2,000.

Independent practice

1. Calculate year 2 depreciation on a $60,000 asset using 25% diminishing balance.
2. A $72,000 machine with $12,000 residual and 100,000-unit capacity produces 16,000 units. Calculate units-of-production depreciation.
3. Carrying amount is $35,000. Revised residual is $5,000 and remaining life four years. Calculate prospective annual depreciation.
4. Explain why the highest-expense method is not automatically the most conservative choice.

Self-check and solutions

1. Year 1 depreciation $15,000; opening year 2 carrying amount $45,000; year 2 depreciation $11,250.
2. Rate = $60,000 ÷ 100,000 = $0.60 per unit; expense = $9,600.
3. ($35,000 − $5,000) ÷ 4 = $7,500 annually.
4. Neutral reporting selects the method that represents consumption. Deliberately biasing expense high can be as misleading as biasing it low.

Retrieval practice

1. Is depreciation a market valuation?
2. What base does diminishing balance use each year?
3. Are estimate changes normally retrospective or prospective?

Answers: no; opening carrying amount; prospective.

Exam-style application

Two identical delivery firms use different defensible methods. Firm A reports lower year-1 profit. Does that prove weaker operations? Explain.

Model response: No. A method with higher early depreciation can lower reported profit without changing sales, cash collected, or physical performance. Compare policies, carrying amounts, operating cash flows, asset ages, and margins before concluding that operations differ.

Lesson summary

Depreciation allocates cost using a supportable consumption pattern. Calculate from the correct base, keep cost and accumulated depreciation separate, and apply new estimates to the remaining carrying amount prospectively.