There are several ways to calculate the depreciation of an asset. Four of the most common ways include:
- Straight line method
- Double declining balance
- Sum of years digits
- Units of production
Companies choose a method that works best for them. In general, depreciation is beneficial for a few reasons. Mainly, it is a legal way for a business to spread out the cost of an asset over a specified period of time. This keeps the business from reporting a large one-time cost that won’t dramatically affect the bottom line in a single reporting period. Rather, the company is allowed to spread out the expense over the life of the asset’s use. Depreciation also helps a company to match the revenues associated with the asset to its total expense.
All of the depreciation methods above, except for the units of production method, calculate an annual depreciation rate which is based on the number of years the asset is expected to be accounted for in use. When useful life is a consideration in calculating depreciation, companies have to divide that value by 12 in order to get the deprecation expense on a pro rata monthly basis. Companies may also use quarterly or half year conventions.
Calculating asset depreciation on a pro rata or proration basis can potentially be an issue in the first and final year of expensing. This means a company will need to calculate the breakdown of annual depreciation as well as a pro rata depreciation and begin applying the schedule for the first month the asset goes into service. This creates assumptions about the date when the property will be placed into service and the date it will be retired.
Companies can adjust their depreciation schedules on a pro rata basis as necessary based on the time the asset actually goes into service. There is also some terminology called the half-year convention, mid-quarter convention, and mid-month convention. Internal Revenue Service code may dictate the type of convention a company must use depending on the asset in focus.
The half-year convention says a company only needs to depreciate one half of a year’s depreciation cost in year one. This would be for an asset that goes into service in July. Moreover, quarterly convention simplifies the pro rate depreciation into quarters depending on the time the asset goes into service. A monthly convention breaks out pro rata depreciation monthly. Generally using pro rata, this means that year one of depreciation will be less than the total annual cost with a final pro-rated amount also calculated in the final year.
Real World Example
Consider an asset a company purchased on September 20, 2019 at the price of $6,000 with five years of useful life, a $0 salvage value, and depreciation under the straight-line method. The company has a fiscal year ending December 31. The annual depreciation expense is $1,200, quarterly depreciation is $300, and the monthly depreciation is $100.
Under the half-year convention, the asset would be considered to be placed in service on July 1, 2019, and the applicable depreciation expense for 2019 is calculated as $1,200 * 0.5 = $600. Since the asset in the example was purchased on September 20, 2019, the company would most likely wait to begin its service on October 1, 2019 in order to more easily account for the depreciation on a pro rata monthly basis. This would mean that the depreciation expense in year one would be $300 ($100 for October, November, and December). This would lead to a pro-rated expense of $900 in the final year, or $100 for each of the first nine months of the final year.
This would make the straight line depreciation period for the asset from October 1, 2019 to September 30, 2024. For other methodologies the accountants would also need to build the depreciation schedule using monthly pro rata conventions rather than annually. The double declining balance and sum of years digits methods are accelerated with higher expenses in the earlier years. This means that breaking down the annual expense into equal monthly allotments would still result in the higher expense for the first 12 months.
Comprehensively, proration of asset depreciation should not create a big problem for companies. However, it can be an important detail for accountants to research and manage when incorporating a new depreciation schedule. Overall, depreciation is used for the benefits of spreading out a substantial cost and also matching incoming revenue with a monthly, quarterly, or annual expense record. As long as the new asset starts contributing to new revenue generation at the time it is put into service, like it is intended to, then the expense begins to become reconciled by a revenue stream over time.