## 2. Useful life revision and financial statement effects

Useful life revision is accounted for prospectively: the change in the estimate is reported in the current and prospective periods. In other words, previously reported statements and opening balances do not need to be adjusted to reflect the change in the useful life estimate.

The reasons prior periods don’t need to be restated are as follows:

• Change in the useful life estimate does not represent an accounting error.
• Estimate changes are an inherent and continual part of the estimation process.

When a change in the useful life estimate occurs, there is no need to make a journal entry. New depreciation rate is recorded at the end of the accounting period.

Let’s look at a simple illustration of the accounting for the change in the useful life estimate. Let’s assume that Dreifach Company (a fictitious entity) purchased machinery for \$150,000. The company made the following estimates at the time of purchase (Year1):

• Useful life: 15 years
• Salvage value: \$0

The company uses the straight-line method to depreciate its machinery. Thus, it has been depreciating the machinery at the following annual rate: \$10,000 = (\$150,000 – 0) ÷ 15 years.

Let’s assume that during Year6 – after five (5) years of using and depreciating the machinery – the company changes its useful life estimate: it assumes that the machinery can be used for 15 years more from the date of change or 20 years from the date of purchase (i.e., if the company had continued using the previous estimate, the machinery would have 10 years, not 15, left when the change was made).

If the company used the 20 year life estimate from the date of purchase, it would be depreciating the machinery at a lower rate: \$7,500 = (\$150,000 – 0) ÷ 20 years.

To see the different effects of the useful life estimates on the depreciation rate, see the table below:

 15-year Life Estimate 20-year Life Estimate Difference Annual depreciation rate \$10,000 \$7,500 \$2,500 Accumulated depreciation (end Year5) \$50,000 \$37,500 \$12,500

Dreifach Company doesn’t need to adjust its prior periods: it will report the change in the depreciation rate in the subsequent periods (i.e., Year6 and on). To calculate the new depreciation rate, the company will divide the remaining book value of the machinery (after 5 years of depreciation) less the salvage value by the remaining estimated life (i.e., 15 years).

Change in depreciation from revision of useful life

 (Historical Cost - Accumulated Depreciation) - Salvage Value = Depreciation Expense Remaining Useful Life
 (\$150,000 - \$50,000) - \$0 = \$6,667 15 years

For the remaining 15 years, the company would make the following journal entry (i.e., unless it changes the estimates again):

 Account Titles Debit Credit Depreciation expense \$6,667 Accumulated depreciation \$6,667

As we can see from this example, the change in the useful life estimate affects:

• Balance sheet: depreciation expense => accumulated depreciation => fixed asset book value
• Income statement: depreciation expense => net income

In our example, the increase in the useful life estimate decreased the depreciation rate and increased net income. When the useful life revision materially increases the reported net income (i.e., from what would have been reported without revision), companies are required to describe the revision in the footnotes to their financial statements.

The change in the useful life estimate could result in a large increase in net income. For example, in 2011 China’s Angang Steel (according to Reuters) prolonged useful life of its buildings, structures, machinery, and equipment, which increased its 2011 net profit by \$121 million. In 2008 Delta Airlines increased the useful life of its flight equipment: depreciation expense decreased by approximately \$127 million and net income (after income taxes) increased by \$69 million.

To learn more about accounting for fixed assets, refer to the tutorial on Accounting for Long-term Assets.

Related accounting tutorials and articles
Not a member?