Question

(Depreciation Concepts) As a cost accountant for San Francisco Cannery, you have been approached by Phil Perriman, canning room supervisor, about the 2017 costs charged to his department. In particular, he is concerned about the line item “depreciation.” Perriman is very proud of the excellent condition of his canning room equipment. He has always been vigilant about keeping all equipment serviced and well oiled. He is sure that the huge charge to depreciation is a mistake; it does not at all reflect the cost of minimal wear and tear that the machines have experienced over the last year. He believes that the charge should be considerably lower.

The machines being depreciated are six automatic canning machines. All were put into use on January 1, 2017. Each cost \(625,000, having a salvage value of \)55,000 and a useful life of 12 years. San Francisco depreciates this and similar assets using double-declining-balance depreciation. Perriman has also pointed out that if you used straight-line depreciation, the charge to his department would not be so great.

Instructions

Write a memo dated January 22, 2017, to Phil Perriman to clear up his misunderstanding of the term “depreciation.” Also, calculate year-1 depreciation on all machines using both methods. Explain the theoretical justification for double-declining-balance and why, in the long run, the aggregate charge to depreciation will be the same under both methods.

Short answer

Answer

During the earlier years of an asset’s life, the double-declining-balance method results in higher depreciation charges because it doubles the straight-line rate which would have been made under the straight-line method.

Step-by-step solution

Step-by-Step SolutionStep 1: Meaning of Depreciation

In an accounting term, depreciation can be referred to as an expense incurred on an intangible asset due to its corrosion and abrasion. A firm may adopt various methods for computing depreciation to reflect the true and accurate value of the asset.

Writing the memo to Phil Perriman

To: Phil Perriman, Supervisor of Canning Room

From:

Date:

Subject: Annual depreciation charge to the canning department

This memo responds to your inquiries concerning the depreciation charge levied against your department. The $625,000 fee seems exorbitant; but, it is not designed to represent the machinery's wear and tear over the previous year. Rather, a portion of the machine's cost has been set aside for this period.

It is generally believed that depreciation indicates a decline in the value of an item over time. Depreciation distributes a portion of an asset's cost for each period over its useful life in a methodical manner for financial statement reasons. Although an asset's value will constantly fall over time, the depreciation charge is a “periodic fee” for utilizing the acquired equipment during any particular period. When you evaluate the impact on your departmental expenditures, the alternative—expensing the complete cost of all six computers this year—is more equitable.

You also suggested that employing straight-line depreciation instead of the existing double-declining-balance technique would result in a lower charge. This is especially true in the equipment's early years. For each canning machine's twelve-year life, straight-line depreciation charges the same amount of depreciation. For this and all the following years, the straight-line charge would be $47,500 per machine, for a total yearly depreciation of $285,000.

Since it is twice the straight-line rate that would have been made under the straight-line technique, the double-declining-balance method results in larger depreciation charges throughout the early years of an asset's life. However, the same percentage depreciation is applied to the asset's diminishing book value each year. As a result, during the asset's latter years of life, the double-declining-balance charge is smaller than the straight-line charge. As previously stated, the price for this year is $625,000, although this expenditure will decrease in the following years. Regardless of the technology used, the same amount of depreciation could be recovered by the end of the twelfth year.

This year, the straight-line strategy would result in fewer charges being filed against your department. Consider this: when the asset is new, the cost of additional servicing and maintenance is modest. As a result, a larger share of the asset's cost should be devoted to this ideal section of its life. Your department will have to bear the increased expense of repair and maintenance after a few years. Wouldn't it be better to have a reduced depreciation charge at that time?

I hope that this explanation resolves the questions you might have concerning the depreciation charges against your department.