What is the Retirement Method of Depreciation
Retirement method of depreciation describes the accounting practice of delaying the depreciation of a fixed asset until it is retired from service. This is in contrast to allocating its costs across the useful life of the asset. At retirement, the depreciation expense is debited and then the asset account for the retired asset is credited. The depreciation expense must be reduced by the asset's salvage value, if any. Public utilities and railroads are the main types of businesses that might use this type of depreciation, though the use of the retirement method of depreciation has fallen into disuse for the most part.
Breaking Down Retirement Method of Depreciation
The retirement method of depreciation, as well as the replacement method of depreciation, are meant to help simplify and reduce the burden of accounting and recordkeeping for companies that own many similar assets that individually are low in value but together represent a significant expense. An electric company might use the retirement method of depreciation to account for the electric meters that are installed on the sides of residents' homes, for example. A railroad may use such methods to avoid detailed and time-consuming depreciation schedule for individual assets, such as ties, conductors, switches, telephones, poles and more. The common theme is the ownership of a large number of smaller items that represent relatively small sums when taken individually.
Retirement Method of Depreciation vs. Replacement Method
How the retirement method of depreciation and the replacement method of depreciation differ is retirement method charges the cost of the retired asset (minus salvage value) to depreciation expense. Meanwhile the replacement method charges the cost of the asset purchased (minus salvage value from the asset retired) to depreciation expense. This means that the retirement method follows a FIFO (first in, first out) flow because the first asset to be expensed will be the first asset purchased. By contrast, the replacement method follows a LIFO (last in, first out) flow because the first asset expensed was the last asset purchased.
Retirement Method of Depreciation Issues
The retirement method of depreciation has a number of issues. They include:
- The fixed assets of a company are frequently overstated because they are not seeing a reduction via an ongoing depreciation charge.
- Since expenses are deferred, reported income may not be accurate (depreciation expense is understated while net income is overstated).
- Since the expenses of a business are being deferred, any financial performance data for it is likely to be inaccurate (biased toward the positive side).
- An accurate allocation of costs to all periods does not occur, especially in the early years.