Question

(Unit, Group, and Composite Depreciation) The certified public accountant is frequently called upon by management for advice regarding methods of computing depreciation. Of comparable importance, although it arises less frequently, is the question of whether the depreciation method should be based on consideration of the assets as units, as a group, or as having a composite life.

Instructions

1. Briefly describe the depreciation methods based on treating assets as

(1) units and

(2) a group or as having a composite life.

1. Present the arguments for and against the use of each of the two methods.
2. Describe how retirements are recorded under each of the two methods.

Short answer

Answer

The unit method of recording depreciation involves the treatment of plant assets or substantial additions thereto as individual items. Under the group or composite-life methods, assets are aggregated into accounting units.

Step-by-step solution

Step-by-Step SolutionStep 1: Meaning of Composite Depreciation

Composite depreciation combines a group of depreciating assets into a single entity rather than treating each item separately. In simple words, it is the application of straight-line depreciation to a portfolio. If an asset is sold, a debit is made to cash, and a credit is made to fixed assets.

(a1) Explaining the depreciation methods based on treating assets as units.

Plant assets or considerable additions to them are treated as discrete items under the unit method of calculating depreciation. The strategy requires keeping meticulous records of the expenditures of certain assets as well as the cumulative depreciation associated with them.

The projected useful life of the specific asset is used to calculate depreciation. The approach differs from group and composite-life methods, in which the asset's cost and predicted life are combined. Straight-line, accelerated, and other acceptable calculating methods can be used to record depreciation.

(a2) Explaining the depreciation methods based on treating assets as units of a group or as having a composite life.

Assets are aggregated into accounting units using the group or composite-life procedures. A horizontal, vertical, or geographical grouping might be used. Trucks, presses, returnable containers, and other assets with comparable physical qualities are grouped together horizontally.

All assets contributing to a shared economic function, such as a sugar refinery or a service station, are included in a vertical or functional grouping. All assets in a district or area, such as telephone poles, are included in the geographical grouping.

The formulation of a weighted-average rate from the assets' depreciable costs and anticipated lifespan is required for depreciation under these approaches. Each asset grouping's total cost and cumulative depreciation are tracked separately in separate accounts. To attain a consistent average life, the asset grouping should consist of a significant number of units.

(b) Presenting the arguments for and against the use of each of the two methods

The following are some arguments for using the unit approach:

1. The technique is simple in that it does not need complex mathematical calculations.
2. ii. It is possible to calculate the gain or loss on the retirement of a certain asset.
3. iii. Depreciation on idle equipment can be segregated for cost considerations.
4. The technique yields a more accurate depreciation provision in any given year because the total depreciation charge represents the best estimate of each asset's depreciation, rather than the cost averaged over a longer period of time.

The following are some of the arguments against the unit method:

1. To account for each asset and its associated depreciation, a significant amount of additional accounting is required. (However, computers lighten the workload.)
2. ii. Under this system, there is a point of decreasing returns in the collection of accounting data, i.e., increased accuracy may not justify the increased expense of record-keeping.
3. iii. In a decentralized financial control system, where a division's efficiency is measured by the rate of return on the gross book value of the investment, a division manager might scrap fully or nearly fully depreciated equipment, even if it is still serviceable, to improve the division's rate of return.
4. Due to the obvious effect of the loss on the division's profitability in the year of replacement, a division manager may be hesitant to replace non-fully depreciated equipment with more efficient equipment.

The following are some of the benefits of using the group and composite-life methods:

1. They need less thorough recordkeeping.
2. ii. Applying depreciation to the entire group has the effect of averaging out or offsetting economic or operational faults produced by under- or over-depreciation.

The following are some of the arguments against using the group and composite-life approaches:

1. The methods would hide erroneous estimations for a long time.
2. ii. If assets are retired early and heavily, a debit balance in the Accumulated Depreciation account may arise, causing an accounting difficulty.
3. iii. For cost-calculation reasons, information about a specific machine is unavailable.
4. In a decentralized financial control system, where the rate of return on the gross book value of the investment is a measure of the division's efficiency, a division manager might scrap idle but serviceable equipment or equipment that does not earn a satisfactory return on book value to improve the division's financial reports. The corporation would suffer an actual loss equal to the value of the discarded equipment.
5. v. In the same circumstance as "iv" above, but using net book value, where the assets are serviceable but completely or almost entirely depreciated, the division manager may be hesitant to replace them due to the high rate of return on investment.

(c) Explaining how the retirements are recorded under each of the two methods

Retirements are reported using the unit approach, which involves eliminating the asset's cost as well as any accrued depreciation from the accounts. Gain or loss is determined by the difference between the two accounts after adjusting for salvage and disposal charges, if applicable.

The cost of the retired asset is withdrawn from the asset account, and the Accumulated Depreciation—The plant assets account is decreased by the amount of the retired item's cost, adjusted for salvage, salvage charges, and removal costs, using the group and composite-life methods. As a result, there is no periodic recognition of gain or loss; instead, the Accumulated Depreciation—Plant Assets account functions as a holding account for gain or loss recognition until the ultimate asset retirement.