Composite Depreciation reduces overhead, lowers the risk of accounting errors, and makes asset management more efficient.
Most businesses require expensive capital assets to operate and earn income. The process of acquiring these assets always involves two kinds of decisions:
- The ownership decision. Will the company simply acquire asset access and usage right or, instead, purchase and own the assets?
- The financing decision. Will the firm acquire usage rights by rental or operating lease, or instead will it borrow, use cash, or capital lease to take ownership?
The more expensive the asset, the more complex the financial and ownership issues can become, in both kinds of decisions. The purchase option also creates complexities for the firm's accountants—especially when buying groups of similar assets: large numbers of vehicles, machines, instruments, computers, furniture items, or store equipment, for instance. The firm must turn all of the purchase expenditures into series of depreciation expenses over multiple asset lives. The method of Composite Depreciation can simplify depreciation accounting in such cases.
Assets Group Membership
Different individual` assets qualify for membership in a single composite depreciation group if the assets all belong to the same class. For this purpose, class means either one of two conditions
- The assets all have roughly the same purpose and roughly similar service lives. In this way, a single depreciation group might include copiers, printers, laptop computers, and telephone switching equipment because they are all "Office Equipment" with expected service lives of 3-5 years.
- The individual assets together make up a larger asset. A building's framework, air conditioning system, water heater heater, and roof are all part of a larger asset, the building.
Explaining Composite Depreciation in Context
Examples below show how one firm uses composite methods for depreciating office equipment assets, but the same approach applies just as well to many other asset classes. Sections below explain group depreciation in context with related terms, emphasizing three themes:
- First, defining the composite depreciation (or group depreciation) as an accounting term, and identifying kinds of assets that are often handled efficiently with the composite approach.
- Second, example calculations showing how to depreciate a group of assets as a single depreciable entity.
- Third, identifying special situations that call for adjustments to the simple composite scheme, such as when the firm removes some assets from the group during the group's depreciable life.
- What is "composite depreciation?"
- Example calculations for composite depreciation: Office Equipment.
- How does composite depreciation expense appear on financial statements?
- Where is composite depreciation on the Income statement?
- Where is composite depreciation on the Balance sheet?
- What happens when assets leave the group?
As an example, suppose that Grande Corporation owns and uses a large number of expensive resources in quite a few different categories. Many resource items, moreover, qualify as Balance Sheet assets. And, for holdings in specific classes, the firm's accountants calculate and claim depreciation expense every year, while these assets serve out their depreciable lives. Usually, moreover, owners derive and claim the depreciation expense separately for each eligible item.
For certain asset classes, however, the item-by-item approach presents accountants with a task that is especially labor-intensive. The work, moreover, can generate copious detail that has little or no value for owners, tax authorities, or auditors. "Office Equipment" is, arguably, an asset class of this kind. For large firms, Office Equipment assets may include hundreds or thousands of similar items, all serving a similar purpose for the business.
Nevertheless, one way or another, Grande corporation must calculate and claim depreciation expense for many Office Equipment items in these categories.
- Laptop Computers
- Copiers & Fax Machines
- Telephone Switching Equipment
Fortunately, most companies can avoid the extra labor and confusion in such cases by turning to methods for Composite or Group Depreciation. Accounting practice almost everywhere must conform to the country and international GAAP (Generally Accepted Accounting Principles). And, GAAP practically everywhere allows composite depreciation, whereby owners depreciate an entire asset group as a single entity.
Examples below illustrate the general approach and principles underlying this method. Before applying composite depreciation in the workplace, however, accountants should consult their country tax authorities for application details.
In this case, Grande's accountants designate the four asset categories as a single asset class "Office Equipment." Group
depreciation begins with a summary of
depreciation information for assets in each of the four office equipment categories.
|Office Equipment Assets|| Original |
| SL Deprec.|
|Copy/Fax Mach||$12,000||$2,000||$10,000||6 years||$2,000|
|Phone Switch Eq||$93,000||$3,000||$90,000||9 years||$10,000|
Notice that composite depreciation will base calculations for all asset categories in the Office Equipment group on the straight-line (SL) method. From these figures, the firm calculates a composite rate and a composite life.
Composite rate = Total depreciation per year / Total original cost
= $33,000 / $176,000
Composite life = Total depreciable cost / Total depreciation per year
= $165,000 / n$33,000
Composite depreciation expense each year equals the composite depreciation rate applied to the total historical cost. Here, assuming no assets join or leave the asset set, composite depreciation for each of five reporting years is:
Composite Depreciation Expense = (0.188 ) ($176,000) = $33,088
Depreciation is a mechanism by which owners turn asset purchase costs into expenses over some years. They charge the depreciation expense against income each year, as the assets are "used up" or "worn out" over their depreciable lives.
Depreciation expense serves in this way so that asset owners to apply a universally recognized principle in accrual accounting—the matching concept. "Matching" means:
- Firms report incoming revenues in the period they earn them.
- They report in the same period expenses incurred to earn them.
In brief, matching means that firms report revenues along with the expenses that brought them. The matching concept, in turn, supports accuracy in reporting profits.
Accounting transactions impact financial statements
It should be no surprise, therefore, that the process of turning asset purchase costs into expenses—depreciation—affects the firm's primary financial accounting statements. Impact begins when firms "claim" or "charge" depreciation expense for the reporting period.
A single depreciation expense brings two accounting system transactions.
- Firstly, a debit (decrease) in a "Depreciation expense account," an "Income statement account." This account is also a noncash account, incidentally, but depreciation expense nevertheless lowers bottom line profits just as all other "expenses" lower profits.
- Secondly, a credit (increase) to an "Accumulated Depreciation account," a Balance sheet contra-asset account.
Composite depreciation—along with all other depreciation schedules and methods—merely results in expense figures. These impact the Income statement as debits to Depreciation expense accounts.
- On detailed Income statements, firms may use several line items—Depreciation expense accounts—for different asset classes. They may, for instance, report depreciation expenses separately for asset groups such as Selling Equipment, Office Equipment, and Manufacturing Equipment.
- Composite depreciation—like other depreciation expenses—has a position on the Income statement consistent with the asset's role in the business:
- Depreciation expense for Manufacturing equipment could appear above Gross Profit under "Manufacturing Overhead." In this case, depreciation expense impacts Gross Profit, as well as Operating Profit and Net Profit below.
- Alternatively, depreciation expense could appear below Gross Profit but above Operating Profit.
The $33,000 Office Equipment composite depreciation expense above might belong in that position. In that case, the depreciation expense impacts Operating Profit and bottom line Net Profit, but not Gross Profit.
In brief, depreciation expense lowers Income statement profits each year that owners claim it. There is a particular benefit to this, however. For companies that pay taxes on operating income, lower profits also mean a lower income tax liability. For this reason, depreciation expenses are said to bring tax savings.
In financial accounting, depreciation is an expense. And, Accountants define "expense" by referring to Balance sheet terms (1) Owners Equity and (2) Assets. The expense definition is as follows:
An expense is a decrease in Owner's Equity caused by using up Assets.
Depreciation expense "uses up" assets by decreasing their Balance sheet book value. And, a decrease in the firm's overall book value means the same thing as a decrease in owner's equity.
The depreciation expense impacts the Balance sheet when it adds to the contra asset account Accumulated Depreciation. Each period of the asset's depreciable life, the firm subtracts Accumulated Depreciation from asset book value, thereby lowering overall book value.
It is of course very likely that the firm will sell or otherwise dispose of some individual assets in the composite depreciation group during the five-year period. When a firm sells an asset:
- The firm debits (increases) a cash account for the sales price received. This not necessarily the same as the original cost of the asset.
- The firm credits (decreases) the asset account for the asset.
- Anything remaining of the charge passes through to Accumulated Depreciation.
Composite depreciation does not allow recognition of any gains (capital gains) or losses (capital losses) on the sale of assets.