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4.3 Attribution of depreciation and amortization
Publication date: 31 Oct 2022
us PP&E and other assets guide
Determining the appropriate period and method to depreciate or amortize assets requires judgment and an understanding of the assets and their useful lives.
4.3.1 Commencement and cessation of depreciation or amortization
Depreciation or amortization of a long-lived asset begins when the asset is available for its intended use. That is, depreciation or amortization begins when the asset is in the location and condition necessary for it to operate in the manner intended by management.
As noted in ASC 835-20-25-5 and ASC 350-40-25-14, interest capitalization should cease and depreciation should begin when the long-lived asset is substantially complete and ready for its intended use. The proposed PPE SOP (see PPE 1.1) describes “ready for its intended use” as follows.
Excerpt from paragraph 28(b) of the proposed PPE SOP
PP&E is considered ready for its intended use when it is first capable of producing a unit of product that is either saleable or usable internally by the entity.
The date on which a long-lived asset is considered ready for its intended use should not be delayed by activities undertaken by the entity in pursuit of efficiency, productivity, or quality enhancements. Similarly, depreciation or amortization of an asset that is available for its intended use should not be delayed simply because the entity has not started operating the asset (e.g., sufficient capacity exists with current production assets).
Certain conditions may prevent a long-lived asset from being considered available for its intended use. For example, if FDA approval is required before a pharmaceutical company can start to manufacture a new drug for sale, depreciation of the manufacturing equipment will generally not commence until the relevant FDA approval is obtained.
Reporting entities often purchase additional spare parts for key pieces of equipment to ensure downtime is minimized in the event of equipment failure. As discussed in PPE 1.5.3 and FSP 8.6.6, depending on the facts and circumstances associated with the spare parts, companies classify spare parts either as long-lived assets or as inventory. When treated as inventory, the spare parts are not depreciated and are expensed when placed in service, similar to maintenance expense. When considered to be long-lived assets, the spare parts are depreciated over their useful lives or the remaining service lives of the related equipment. Determining when to start depreciating a spare part that meets the definition of long-lived asset will depend on its expected use. If the spare part is expected to be used only if there is an unexpected breakdown or equipment failure, it may be appropriate to start depreciation at the point when the spare part is available for installation. On the other hand, if that spare part is expected to be routinely used as a replacement part, it may be appropriate to start depreciation when the spare part is installed.
Example PPE 4-2 illustrates when to begin depreciation of a newly installed asset.
EXAMPLE PPE 4-2
When to begin depreciation of a newly installed asset
When to begin depreciation of a newly installed asset
PPE Corp installs a new production line to produce plastic containers. Commercial production cannot begin until PPE Corp receives routine quality approval from its key customer.
Does PPE Corp need to defer the commencement of depreciation until the quality approval is obtained?
Analysis
Depreciation should commence when the production line is substantially complete and ready for its intended use. Because the quality approval is considered to be routine in nature, PPE Corp should not defer recognition of depreciation until approval is received from the customer. If, however, the plastic containers are highly customized (e.g., requiring specialized technology or engineering) and the customer delays granting approval pending a significant modification to the asset or related process, the asset may not be ready for its intended use until customer approval is obtained.
Depreciation ceases when an asset is derecognized or when the asset is classified as held for sale in accordance with ASC 360-10-35-43. Therefore, depreciation generally does not stop when an asset is temporarily idled. However, if an asset or component of an asset remains idle for more than a short period of time, it may indicate a potential impairment or demonstrate the need to reassess the asset’s useful life. For further details regarding held for sale accounting, see PPE 5.3. See PPE 4.4 for further discussion of component depreciation.
Judgment is required to determine whether a productive asset is temporarily idled or permanently abandoned. See PPE 6.3.1 for further information regarding assets abandoned or to be abandoned.
Depreciation would also cease when an asset’s accumulated depreciation equals its cost minus salvage value, if any. A reporting entity will often continue to record a fully depreciated asset on the balance sheet and disclose the asset in the footnotes to the financial statements at its cost along with its accumulated depreciation (i.e., at a net carrying amount of zero) until such time that the asset is physically disposed of or sold.
When a reporting entity expects to sell an asset significantly before the end of its previously estimated useful life and the asset does not meet the held for sale criteria, the reporting entity should continue to depreciate the asset, even if it expects to sell it at a gain. Although fair value may be higher than book value, depreciation should continue until the asset either is disposed of (or meets the held for sale criteria) or is depreciated to its salvage value. Long-lived assets should not be written up to reflect appraisal, market, or current values above the book value. As noted in ASC 360-10-35-4, depreciation is “a process of allocation, not of valuation.” Unless an asset is disposed of (or meets the held for sale criteria), ceasing depreciation would distort the allocation of the initial cost of the asset over its useful life (see Example PPE 4-1 in PPE 4.2.3).
4.3.2 Depreciation of tangible assets
Depreciation accounting is a system of accounting that aims to distribute the cost of a tangible asset, less salvage (if any), over its estimated useful life in a systematic and rational manner. Several methods of depreciation exist that achieve this objective, including the straight-line method, accelerated methods (such as sum-of-the-years’-digits and declining-balance methods), and the units-of-production method. In selecting a method of depreciation for a given asset, the factors to consider include whether (1) the asset is subject to rapid obsolescence, (2) deterioration is a function of time or usage, (3) productivity declines with time, and (4) the cost of repairs and maintenance increases with time.
The Accelerated Cost Recovery System (ACRS) and Modified Accelerated Cost Recovery System (MACRS) are methods of depreciating property for tax purposes that allows individuals and businesses to write off capitalized assets in an accelerated manner. Assets are assigned to various classes, which are used as the basis for depreciation. There are similar systems in other tax jurisdictions. In accordance with ASC 360-10-35-9, the use of the ACRS for book depreciation purposes is allowed only when the number of years specified by the ACRS for recovery deductions for an asset falls within a reasonable range of the asset’s useful life.
ASC 360-10-35-10 prohibits the annuity method of depreciation, which is a method under which the amount spent acquiring an asset is assumed to be an investment that should earn interest based on a predetermined return rate and calculated based on annuity tables.
4.3.2.1 Straight-line method of depreciation
The straight-line method is the most common depreciation model used in practice and is appropriate when the pattern of consumption of an asset’s economic benefit is expected to be delivered steadily over the estimated useful life and the production capacity will not decline over time. The straight-line method may also be appropriate if the pattern of consumption cannot be reliably determined. Under the straight-line method, the cost of the asset, less the estimated salvage value, is charged to the income statement ratably over the asset’s estimated useful life.
4.3.2.2 Accelerated methods of depreciation
The economic benefits of an asset may decline more rapidly in the earlier years of the asset’s life. An asset may become less reliable and more likely to break-down, less capable of producing a high-quality product, or less technologically advanced in later years of its life. ASC 360-10-35-7 describes when an accelerated method may be appropriate.
Excerpt from ASC 360-10-35-7
If the expected productivity of the asset or ability of the asset to generate revenue is relatively greater during the earlier years of its life, or maintenance charges tend to increase during later years, the declining-balance method may provide the most satisfactory allocation of cost. That conclusion also applies to other methods, including the sum-of-the-years'-digits method, that produce substantially similar results.
Under the declining-balance method, a constant rate is applied to the beginning balance of the remaining depreciable base to calculate the depreciation charge for the current period. For the sum-of-the-years’-digits method, the depreciable base (initial asset cost less salvage value, if any) is multiplied by the remaining years of the asset’s useful life divided by the sum of the asset’s original useful life in years (see Example PPE 4-3).
When applying an accelerated depreciation method, a reporting entity will often plan to change to the straight-line method at a specific point in the service life to fully depreciate the cost over the estimated life of the asset. Example PPE 4-3 illustrates accelerated deprecation methods.
EXAMPLE PPE 4-3
Accelerated depreciation methods
Accelerated depreciation methods
PPE Corp buys a piece of manufacturing equipment at the beginning of the year for $100,000. The equipment is not expected to have any salvage value at the end of its 10-year useful life.
How is depreciation expense calculated using the declining-balance method and the sum-of-the-years’-digits method?
Analysis
Declining-balance method
The most common declining-balance method is double-declining-balance. To calculate the constant depreciation rate, the annual rate of depreciation (calculated as 1 over the useful life) is multiplied by 2. In this example, the constant rate would be 20% (1 / 10 × 2). Depreciation expense in the first year would be $20,000 ($100,000 × 20%). In the second year, the same constant rate would be applied to the remaining balance and depreciation expense would be $16,000 (($100,000 - $20,000) × 20%)). The same constant rate would be applied to the remaining balance in each successive year throughout the asset’s remaining useful life.
Sum-of-the-years’-digits method
Depreciation expense in any given year is calculated as the initial cost, net of salvage value, multiplied by a fraction—the numerator of which is the remaining years of useful life and the denominator of which is the sum of the digits comprising the original life of the asset. In this example, because the equipment is expected to have a ten-year useful life, the digits 1 through 10 are added together (i.e., 1 + 2 + 3, etc.) to determine the denominator of 55. Depreciation expense in year 1 would be $18,182 ($100,000 × 10/55). In year 2, depreciation expense would be $16,363 ($100,000 × 9/55), with the same methodology used in each successive year throughout the asset’s useful life.
Regardless of the method elected, total depreciation expense over the life of an asset will be the same as the total depreciation expense using the straight-line method. An accelerated depreciation method will result in greater depreciation expense in the early years of an asset's useful life and less depreciation expense in the later years as compared to the straight-line depreciation method.
4.3.2.3 Units-of-production method of depreciation
The units-of-production method relates depreciation to the asset’s estimated use or output. The rate of depreciation per hour of usage or unit of production is derived by dividing the depreciable amount by the asset’s estimated total service capability, measured in terms of hours or units. This method is sometimes employed when the asset’s usage varies considerably from period-to-period to more accurately reflect consumption of the economic benefits.
For example, assume a machine costs $50,000, with a salvage value of $5,000. The total usage of the machine is expected to be 100,000 hours. The depreciation rate per hour’s usage is therefore $0.45 (($50,000 - $5,000) / 100,000 hours). If the actual usage is 20,000 hours in a given year, depreciation would be $9,000 ($0.45 × 20,000 hours).
4.3.2.4 Modified units-of-production method of depreciation
Straight-line depreciation is based on the premise that depreciation of a productive asset is a function of time, not usage. Units-of-production depreciation is based on the premise that depreciation of a productive asset is a function of usage, not time. Modified units-of-production (MUP) depreciation, sometimes referred to as modified straight-line depreciation, is a hybrid of these two depreciation models. MUP depreciation is based on the premise that depreciation of a productive asset is a function of both time and usage. MUP depreciation is uncommon in practice, especially relative to straight-line and accelerated depreciation methods.
Under MUP depreciation, within a broad range of production levels (the “variable production range”), depreciation is directly proportional to usage (sometimes measured by level of output). At extreme levels of production, this relationship succumbs to the time element, and the productive asset is considered to have a minimum and maximum economic useful life in years, regardless of usage. This is especially important when the asset is operated at extremely low production levels; establishing a maximum economic useful life precludes the possibility that the asset's depreciable life would be extended indefinitely, or beyond the asset’s productive life.
In constructing an MUP depreciation formula, consideration should be given to choosing the measure of asset usage—the “unit” in units-of-production. The unit may be defined in terms of asset usage (e.g., days used for drilling rigs) or asset production (e.g., tons of steel produced for steelmaking machinery and equipment). The objective is to select the measure of asset usage that bears the most direct relationship to the usefulness of the asset within the variable production range. Production processes that involve numerous individual assets or produce several different products may pose difficulties in choosing the most appropriate measure of asset usage. An inability to select a meaningful measure of asset usage may indicate that MUP depreciation is either inappropriate or impractical and instead, another method should be used.
4.3.2.5 Group and composite depreciation methods
Multiple-asset groups may be depreciated in one of two ways: the “group” method and the “composite” method. The group method can only be used for groups of assets that are largely homogeneous and have approximately the same useful lives (e.g., telephone poles). When applied to a largely homogeneous population, the group method closely approximates a single-unit depreciation profile because the dispersion from the average useful life is not meaningful. The composite approach may be used in limited circumstances for closely related heterogeneous assets that have different lives (e.g., individual assets in a power plant). Under both methods, a reporting entity depreciates the balance over the average life of the assets in the group.
To apply the group or composite method of depreciation, a reporting entity should have quantitative data to support the use of the method, such as the dispersion of useful lives from the average for the group. Updated depreciation studies are usually performed on a regular basis to support ongoing use of the group or composite method. The frequency of the study is a function of the extent of changes since the last study. For example, more frequent or immediate studies may be appropriate in circumstances when a reporting entity experiences a significant and unplanned level of retirements. Significant and unplanned retirements may change the key characteristics of the group of assets (e.g., average age, average remaining life) such that the previous depreciation rates may no longer be a reasonable estimate of the assets’ remaining lives. Periodic depreciation studies with regular updates help to ensure that depreciation is recorded over a reasonable estimate of the remaining useful lives of the assets.
In general, absent infrequent or unexpected retirements, and unlike when each asset is depreciated individually, neither the group nor composite method of depreciation results in the recognition of a gain or loss upon the retirement of an asset. Instead, if an asset is retired before or after the average service life of the group is reached, an amount is recognized in accumulated depreciation for the difference between the original cost of the asset and any consideration received upon retirement or disposal. The result is that any gain or loss on disposal of an individual asset is reflected in accumulated depreciation; no gain or loss on disposal is recognized in earnings. The group and composite methods tend to smooth any potential differences caused by over- or under-depreciation.
However, when there are unforeseen or unexpected retirements, a gain or loss should be recognized in earnings. For example, the early retirement of an entire generating station due to storm damage would likely be considered unforeseen or unexpected and would result in the recognition of a loss.
Example PPE 4-4 illustrates the application of the group method of depreciation.
EXAMPLE PPE 4-4
Application of the group depreciation method
Application of the group depreciation method
On January 1, 20X1, Telecom Co purchased 1,000 new telephone poles for $100,000 (which included installation), each with an estimated useful life of five years (annual rate of deprecation of 20%). At the time of purchase, there is no expected salvage value. Telecom Co groups all of its telephone poles for purposes of calculating depreciation expense. At the end of two years of service, 100 telephone poles are retired early, and no consideration is received.
How should Telecom Co account for the purchase, depreciation, and retirement of the telephone poles?
Analysis
Telecom Co would record the following journal entries (amounts in thousands):
Dr. Telephone poles |
$100 |
|
Cr. Cash |
$100 |
|
To record initial purchase |
||
Dr. Depreciation expense |
$20 |
|
Cr. Accumulated depreciation |
$20 |
|
To record annual depreciation in years 1 and 2 ($100 / 5 years) |
||
Dr. Accumulated depreciation |
$10 |
|
Cr. Telephone poles |
$10 |
|
To record early asset retirement (100 telephone poles x $0.1 original cost) |
||
Dr. Depreciation expense |
$18 |
|
Cr. Accumulated depreciation |
$18 |
|
To record annual depreciation in year 3 (($100-10) x 20%) |
The total cost of the retired poles would be charged to accumulated depreciation. Depreciation would continue to be recognized for the remaining telephone poles until they are retired. Given the early retirement, Telecom Co may need to evaluate whether the previous depreciation rate of 20% is still a reasonable estimate of the remaining useful life of the group. Once the last asset in the group is retired, a gain or loss would be recognized for any difference between cost and accumulated depreciation.
4.3.2.6 Change in depreciation method
A reporting entity should evaluate both the method of depreciation and the remaining useful lives of its long-lived assets as events and circumstances change. When events occur that trigger the need to assess an asset for recoverability, it may also be necessary to consider whether the method of depreciation and the asset’s estimated useful life continue to be appropriate. See PPE 4.2.3 for further information about changes in useful life.
Consistent with ASC 250-10-45-18, a change from one depreciation method to another (including a change from one accelerated method to another accelerated method) is a change in accounting estimate that is effected by a change in accounting principle. Such changes can only be made if the new method is determined to be preferable.
A change from the unitary method of depreciation to a group or composite method of depreciation is also considered to be a change in depreciation method and is permitted only if the new accounting principle is preferable. Although the composite and group methods are acceptable depreciation methods, the unitary method is generally considered preferable as it better reflects the expected use of individual long-lived assets. Therefore, we generally do not believe it would be appropriate to change methods from the unitary method of depreciation to the group or composite method.
In accordance with ASC 250-10-45-20, a planned change from an accelerated depreciation method to the straight-line method at a specific point in the service life of an asset to fully depreciate the cost over the estimated life of the asset does not constitute a change in accounting principle if this policy is applied consistently.
Whether a change in the method of applying the principle of depreciation is preferable is determined on a case-by-case basis. See FSP 30.4 for further information about changes in accounting principle.
4.3.3 Amortization of intangible assets
An intangible asset that has a finite life should be amortized over its estimated useful life to the entity. If an intangible asset’s useful life is determined to be finite, but the precise length of that life is not known, the intangible asset should be amortized over the entity’s best estimate of the asset’s useful life. The method of amortizing an intangible asset should reflect the pattern in which the asset’s economic benefits are consumed or otherwise used up, as discussed in PPE 4.3.2. If such a pattern cannot reliably be determined, ASC 350-30-35-6 requires use of a straight-line amortization method, as discussed in PPE 4.3.2.1.
A reporting entity should consider the nature of the amortizable intangible asset and its expected use when assessing if the pattern of consumption can be reliably determined or if the straight-line method will provide an appropriate method of amortization. The valuation performed for purposes of measuring the intangible asset’s fair value (if acquired) may also provide a reasonable starting point to discern the expected pattern of economic benefit of an intangible asset. For example, when an income approach is used to measure the fair value of a long-lived intangible asset, the projected cash flows may be the best indication of the pattern of economic benefit expected from the asset, as adjusted for entity-specific considerations.
Consideration should be given to whether discounted or undiscounted cash flows should be used. Judgment should be applied in determining whether discounted or undiscounted cash flows better reflect the pattern of economic benefit the entity may expect to derive from the asset.
At times, it may appear that a finite-lived intangible asset’s economic benefits are consumed toward the latter part of the asset’s life. Before selecting an amortization method that increases in later years, a reporting entity should support the assertion by preparing an analysis that demonstrates that (1) the benefits received from consuming the asset are greater in the latter part of the asset’s useful life and (2) cash flows generated from the asset are consistent with that belief. For example, a fixed-duration customer contract that is not likely to be renewed or extended may generate sales of increasingly larger quantities of a product through the expiration date of the contract. In this instance, the economic benefits are likely to be consumed toward the latter part of the asset’s life. Due to the pattern of consumption for many intangible assets, instances when amortization expense is greater in the later years are expected to be rare.
4.3.3.1 Amortization of customer-based intangible assets
Some intangible assets recognized in a business combination derive their value from future cash flows expected from the customers of the acquired entity. Companies may also recognize this type of intangible asset when they acquire groups of customer accounts in an asset acquisition. Such assets are often measured using an income approach, which uses valuation techniques to convert future amounts (e.g., cash flows or earnings) to a single present value amount (discounted). This approach may also provide evidence as to the assets’ useful lives and the pattern of economic benefit expected to be derived.
Typically, customer relationships within a large group of accounts may dissipate at a more rapid rate in the earlier periods than in later periods. In this circumstance, straight-line amortization over an expected useful life of the group of accounts may overstate net earnings in earlier periods and understate such earnings in later periods. Therefore, customer-based intangible assets should generally be amortized systematically to allocate an amount over the periods expected to be benefited using the pattern of economic benefit. Management should evaluate whether the actual net cash flows from the acquired customer accounts differ (or are likely to differ) significantly from those underlying the original method of allocating the assets’ cost, and revise accounting estimates when necessary.
Although the attribution of the fair value of a customer-related intangible asset may best be reflected based on the pattern of economic benefit, we are aware that in the past the SEC staff has accepted a straight-line amortization method over a shorter term if the pattern of usage or consumption associated with the asset is such that amortization over a longer period of economic benefit would not differ materially from amortization using an accelerated method. Judgment should be applied in determining whether a straight-line method over a shorter term is appropriate.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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