A Change In Depreciation Method Is Accounted For By

A change in depreciation method is accounted for retrospectively when it results in a more accurate and fair presentation of a company's financial position and operating results. It involves adjusting the financial statements of prior periods as if the new depreciation method had been in use all along. This article delves into the intricacies of this accounting practice, covering the reasons behind a change, the procedures involved, the impact on financial statements, and the necessary disclosures.

Understanding Depreciation and Its Methods

Depreciation, in accounting terms, is the systematic allocation of the cost of a tangible asset over its useful life. It reflects the gradual decline in the asset's economic value due to wear and tear, obsolescence, or other factors. Different depreciation methods are available, each designed to allocate the cost in a specific pattern that best matches the asset's consumption of economic benefits.

Straight-Line Method: Allocates an equal amount of depreciation expense each year over the asset's useful life.
Declining Balance Method: Applies a constant rate to the asset's declining book value, resulting in higher depreciation expense in the early years and lower expense in later years.
Sum-of-the-Years' Digits Method: Another accelerated method that calculates depreciation based on a fraction, with the numerator representing the remaining useful life of the asset and the denominator representing the sum of the years' digits.
Units of Production Method: Allocates depreciation based on the actual use or output of the asset, such as machine hours or units produced.

Choosing the appropriate depreciation method is crucial for accurately reflecting the economic reality of asset usage. The selection should be based on how the asset's economic benefits are consumed over time.

Reasons for Changing Depreciation Methods

Companies may change depreciation methods for a variety of reasons, all aimed at improving the accuracy and relevance of financial reporting.

Improved Matching of Expenses to Revenues: The primary goal is to align the depreciation expense with the actual pattern of the asset's consumption of economic benefits. For instance, if an asset is used more intensively in its early years, an accelerated method might be more appropriate.
Changes in Asset Usage Patterns: Over time, a company's usage of an asset may change. What was once best described by the straight-line method might now be more accurately represented by the units of production method if the asset's usage becomes more variable.
Technological Advancements: Technological changes may render an asset obsolete sooner than originally anticipated. In such cases, a change to an accelerated method can better reflect the rapid decline in the asset's value.
Industry Practices: A company may decide to align its depreciation method with industry standards to enhance comparability with its peers. This can be particularly relevant when assessing financial performance within a specific sector.
Regulatory Requirements: While less common, changes in accounting standards or regulations may necessitate a change in depreciation method to comply with the new requirements.

Accounting for a Change in Depreciation Method

When a company changes its depreciation method, it must account for the change retrospectively. This means that the company must adjust its financial statements as if the new method had been in use all along. The retrospective application involves several steps:

Determine the Cumulative Effect: Calculate the difference between the depreciation expense recognized under the old method and the depreciation expense that would have been recognized under the new method for all prior periods. This difference is the cumulative effect of the change.
Adjust Retained Earnings: The cumulative effect is typically adjusted against the beginning retained earnings of the earliest period presented in the financial statements. This adjustment reflects the impact of the change on the company's net income over prior years.
Restate Prior Period Financial Statements: The company must restate its prior period financial statements to reflect the new depreciation method. This includes adjusting the depreciation expense, accumulated depreciation, and net book value of the asset for each period presented.
Disclose the Change: The company must disclose the change in depreciation method in the notes to the financial statements. This disclosure should include the reasons for the change, the cumulative effect of the change, and the impact of the change on current and prior periods' financial statements.

Step-by-Step Procedure for Retrospective Application

To illustrate the retrospective application, let's consider a hypothetical example.

Scenario:

ABC Company purchased a machine on January 1, 2020, for $500,000. The machine had an estimated useful life of 10 years and a salvage value of $50,000. ABC Company initially used the straight-line method to depreciate the machine. On January 1, 2023, ABC Company decided to change to the declining balance method with a rate of 20%.

Step 1: Calculate Depreciation Under the Old Method (Straight-Line)

The annual depreciation expense under the straight-line method is calculated as follows:

(Cost - Salvage Value) / Useful Life
($500,000 - $50,000) / 10 = $45,000 per year

For the years 2020, 2021, and 2022, the total depreciation expense recognized was:

$45,000 x 3 = $135,000

Step 2: Calculate Depreciation Under the New Method (Declining Balance)

The depreciation expense under the declining balance method is calculated as follows:

2020: 20% x $500,000 = $100,000
2021: 20% x ($500,000 - $100,000) = 20% x $400,000 = $80,000
2022: 20% x ($400,000 - $80,000) = 20% x $320,000 = $64,000

For the years 2020, 2021, and 2022, the total depreciation expense that would have been recognized under the declining balance method is:

$100,000 + $80,000 + $64,000 = $244,000

Step 3: Determine the Cumulative Effect

The cumulative effect of the change in depreciation method is the difference between the depreciation expense under the new method and the depreciation expense under the old method:

$244,000 (New Method) - $135,000 (Old Method) = $109,000

Step 4: Adjust Retained Earnings

The cumulative effect of $109,000 is adjusted against the beginning retained earnings of the earliest period presented (2020). This adjustment increases the retained earnings by $109,000, reflecting the increased depreciation expense that would have been recognized under the declining balance method.

Step 5: Restate Prior Period Financial Statements

The prior period financial statements (2020, 2021, and 2022) are restated to reflect the declining balance method. This includes adjusting the depreciation expense, accumulated depreciation, and net book value of the machine for each year.

2020:

Depreciation Expense: $100,000
Accumulated Depreciation: $100,000
Net Book Value: $500,000 - $100,000 = $400,000

2021:

Depreciation Expense: $80,000
Accumulated Depreciation: $100,000 + $80,000 = $180,000
Net Book Value: $400,000 - $80,000 = $320,000

2022:

Depreciation Expense: $64,000
Accumulated Depreciation: $180,000 + $64,000 = $244,000
Net Book Value: $320,000 - $64,000 = $256,000

Step 6: Disclose the Change

The company must disclose the change in depreciation method in the notes to the financial statements. This disclosure should include:

A description of the change in depreciation method.
The reasons for the change.
The cumulative effect of the change on retained earnings.
The impact of the change on the current and prior periods' financial statements (e.g., the adjusted depreciation expense and net book value for each year).

Impact on Financial Statements

The retrospective application of a change in depreciation method can have a significant impact on a company's financial statements.

Balance Sheet: The accumulated depreciation and net book value of the affected asset will be adjusted to reflect the new depreciation method. This can impact the company's total assets and equity.
Income Statement: The depreciation expense for prior periods will be adjusted, which will affect the company's net income. This can also impact various profitability ratios, such as gross profit margin and net profit margin.
Statement of Retained Earnings: The cumulative effect of the change will be adjusted against the beginning retained earnings of the earliest period presented. This can impact the company's total equity and its ability to pay dividends.
Statement of Cash Flows: The retrospective application typically does not have a direct impact on the statement of cash flows, as depreciation is a non-cash expense. However, the adjusted net income can indirectly impact the cash flow from operations.

Disclosures Required

Proper disclosure is essential for transparency and to ensure that financial statement users understand the impact of the change in depreciation method. The required disclosures typically include:

Description of the Change: A clear explanation of the change in depreciation method, including the old method and the new method.
Reasons for the Change: A detailed explanation of the reasons for the change, including why the new method is considered more appropriate.
Cumulative Effect: The amount of the cumulative effect of the change on retained earnings, presented separately.
Impact on Prior Periods: The impact of the change on the financial statements of prior periods, including the adjusted depreciation expense, accumulated depreciation, and net book value for each period presented.
Any Other Relevant Information: Any other information that is relevant to understanding the change and its impact, such as the estimated useful life and salvage value of the asset.

Practical Considerations and Challenges

While the retrospective application of a change in depreciation method is conceptually straightforward, it can present practical challenges.

Data Availability: Gathering the necessary data to calculate the cumulative effect and restate prior period financial statements can be challenging, especially if the change involves assets that were acquired many years ago.
Complexity: Calculating the depreciation expense under different methods for multiple periods can be complex and time-consuming.
Auditing: Auditors will scrutinize the change in depreciation method to ensure that it is justified and that the retrospective application is accurate.
Communication: Communicating the change and its impact to financial statement users can be challenging, especially if the change is significant.

Examples of Acceptable and Unacceptable Justifications

To provide further clarity, here are examples of acceptable and unacceptable justifications for changing depreciation methods:

Acceptable Justifications:

A company changes from the straight-line method to the units of production method because the asset's usage has become more variable and the units of production method better reflects the actual consumption of economic benefits.
A company changes from an accelerated method to the straight-line method because the asset's usage has become more consistent over time and the straight-line method now better reflects the pattern of economic benefit consumption.
A company changes its depreciation method to align with industry standards, enhancing comparability with its peers.

Unacceptable Justifications:

A company changes its depreciation method solely to reduce its tax liability without any change in the asset's usage or economic benefits.
A company changes its depreciation method to smooth its earnings or manipulate its financial results without any valid justification.
A company changes its depreciation method without disclosing the change or providing adequate justification.

Conclusion

A change in depreciation method is accounted for retrospectively to ensure that financial statements provide a fair and accurate presentation of a company's financial position and operating results. This involves adjusting prior period financial statements as if the new method had been in use all along. While the retrospective application can be complex and challenging, it is essential for maintaining the integrity and reliability of financial reporting. Companies must provide clear and transparent disclosures to ensure that financial statement users understand the reasons for the change and its impact on the financial statements. By adhering to these principles, companies can enhance the credibility and usefulness of their financial reporting.