Component and group depreciation

September 14, 2014

Depreciation might sound simple in theory - the company buys a fixed asset and then writes off the cost over a period of time. But what if a company has hundreds or thousands of depreciable assets, each with its own cost, salvage value, and useful life? What if a particular machine has several dozen separate parts that must be replaced at different times? Situations like this call for specialized methods of depreciation.

1. Component depreciation

When a fixed asset has separately identifiable pieces with separate values, each part can be independently depreciated. The asset itself is assigned the rest of the cost and is depreciated as if it’s another component. This method of depreciation is permitted under U.S. GAAP.

As an illustration, let’s assume that Friends Company, a fictitious entity, purchases manufacturing equipment that includes three separately identifiable components - a large piston that wears out every 5 years, a major torque arm that has to be replaced every 3 years, and a compressor which is expected to be in use for 5 years before being replaced. Let’s assume that the entire machine costs $2 million and is expected to be in use for 30 years; the piston costs $200,000; the torque arm costs $60,000; and the compressor costs $20,000. Each year, Friends Company will record depreciation of $40,000 for the piston (i.e., $200,000 ÷ 5 years), $20,000 for the torque arm (i.e., $60,000 ÷ 3 years), $4,000 for the compressor (i.e., $20,000 ÷ 5 years), and $57,333 (i.e., $1,720,000 ÷ 30 years) for the machine itself.  Note that the cost of machine itself is calculated as: $2,000,000 - $200,000 - $60,000 - $20,000 = $1,720,000.  The total annual expense equals $121,333 (i.e., $40,000 + $20,000 + $4,000 + 57,333). Using standard straight line depreciation, the expense would have been $66,667 per year (i.e., $2,000,000 ÷ 30 years).

Notice that for regular depreciation methods (i.e., without splitting the cost of an asset into separate components), component replacement is treated as a repair/maintenance expense, which is debatably inappropriate for large, easily identifiable components.

2. Group depreciation

A company with a large number of depreciable assets may decide to split them up into one or more groups and depreciate each group using the total depreciable base (cost) of all assets in the group – original cost minus salvage value – and an average estimated useful life and depreciation percentage.

Because the depreciation is averaged out over the entire group of assets, selling one of the assets does not result in any gain or loss. Instead of an income statement effect, the sale will merely reduce accumulated depreciation for the difference between original cost and the cash received. In essence, the asset is treated as being sold for book value.

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