Editor’s note: The following is a supplement to the author’s “Depreciable Asset Lives: The Forgotten Estimate in GAAP,” published in the September 2016 CPA Journal.
Composite depreciation is a method that entails grouping property items and applying an average estimated useful life to each asset group for depreciation purposes. Although FASB speaks of long-lived asset groups in terms of business combinations, impairments and disposals, it provides definitions and guidance as to “group” versus “unit” depreciation only with specific reference to the airline industry and (unfortunately) states without qualification that “ease of application is the [only] basis of selection” (ASC 908 360-35-1). Notwithstanding this, in its definitions that follow, FASB suggests (but does not require) that “unit depreciation is generally used for fixed assets … that have large unit costs and are comparatively few in number,” and that “group depreciation usually is applied to groups of assets that are significant in number but have relatively small unit values.” In practice, group depreciation is commonly used for such things as manufacturing facilities and hotels, and groupings may be by any logical categories, such as year of acquisition, by specific type of asset or classification (e.g., all machinery), by location, or by a combination of these. Except in unusual circumstances, no gains or losses (or retroactive depreciation adjustments) are recognized upon disposition when a composite or group depreciation technique is used.
Composite or group depreciation has been a practical alternative to depreciating individual assets by components (unit or “component” depreciation), which is generally preferable when there are large variances in actual economic useful lives among the assets. Given the relative ease with which inexpensive accounting software can track depreciation for individual assets, however, composite depreciation is not as attractive an alternative as it once was, which may explain its rare usage today.
Although required under IFRS, the term component depreciation is not universally understood or used in the United States, nor is it mentioned at all in U.S. GAAP. According to nonauthoritative interpretive analysis material published online by Commerce Clearing House’s Accounting Research Manager (ARM), the term is often used when replacement components of a larger asset are significant in cost and have shorter lives than the basic unit. The term is also used in other nonauthoritative literature as a synonym for unit depreciation, as that term is used and defined by FASB, as well as to describe circumstances wherein large, complex assets (e.g., buildings) are broken down into components, most often at the time they are constructed or acquired, to enable the use of shorter lives for components likely to be replaced during the life of the larger asset.
When properly applied, ARM suggests that component depreciation may be preferable because it likely “will result in a more accurate determination of depreciation and will facilitate accounting when the component is replaced.” Its use in the United States, however, appears to be primarily motivated by tax benefits. It appears that component depreciation is not an alternative to group depreciation, but rather may be used in combination with either group or unit depreciation techniques. Thus, despite any implications in some sources to the contrary, these terms are not necessarily always synonyms—clearly, under FASB’s definitions discussed above, they are antonyms.
GASB prefers using composite depreciation over group depreciation. It does not define or discuss component or unit depreciation. Although the composite method is authorized explicitly for use by governments by GASB Codification 1400.174-.179, by FASB only for airlines, and as appropriate by the SEC staff (SAB Topic 10A, C, and D) for electric utilities, it is not mentioned anywhere else in authoritative GAAP; nevertheless, composite depreciation is generally considered acceptable in practice. In this author’s opinion, however, auditors should be cautioned to accept it only when variances in estimated useful lives are not so large as to unduly skew the average lives assigned and when it can otherwise be safely demonstrated that use of the technique produces no material distortion, in either the statement of operations or the balance sheet, as compared to a more robust and precise method. Consequently, when composite depreciation is used, periodic studies should be undertaken to ensure that the average life being used is appropriate and that no material misstatements are accumulating in the balance sheet.