Depreciation

Depreciation is a concept most commonly associated with long-lived assets, such as property and equipment, and represents a process whereby the cost of the assets, less any residual or salvage value, is charged to income in a rational and systematic manner over the estimated useful life of that asset. Depreciation is a process of allocation, not valuation.

The key elements in the process of depreciation accounting are the estimate of the useful life of the asset and the method used. The useful life must contemplate obsolescence caused by technological or other changes, and the pattern of wear and tear caused by physical usage. The depreciation method used is typically based on a function of time or actual physical usage.

Useful lives of medical equipment and facilities are typically based on prior experience with similar assets or on commonly accepted guidelines in the industry. The American Hospital Association's Estimated Useful Lives of Depreciable Hospital Assets is an example of such a source. The estimate of a useful life for a particular asset in the health care industry should consider the rapid changes in technology in this industry and the likelihood of equipment made obsolete or inadequate by technological advances.

A variety of depreciation methods are used in the depreciation accounting process to allocate the cost of the asset over its estimated useful life. Again, the method must be systematic and rational and, in theory, match the cost of the asset with the revenue that asset produces over a period of time.

One of the most common methods of depreciation is a straight-line method. This method is simple and is easily applied. The straight-line method is theoretically acceptable when the decline in the economic utility of the asset is a function of time rather than usage. This method also assumes a consistent use in each period over the life of the asset and a consistent level of maintenance.

Other depreciation allocation methods based on time reduce depreciation charges over the life of the asset. In other words, under these methods depreciation expense is higher in the early years of the asset's life and lower in later years. These accelerated methods are theoretically acceptable when the contribution of the asset to the organization's operations is greater in the early years and declines over time. Another underlying premise in these methods is increasing maintenance costs over time, so that the total cost related to the asset is held somewhat level.

The accelerated methods of depreciation are varied as to the mechanics used in the calculations to allocate depreciation over the estimated useful life of the asset. The most common are declining balance and a “sum-of-the-years-digits” method. They both accelerate depreciation.

The declining balance method simply applies an assumed constant depreciation rate to the net cost of the asset each period. Therefore, as the net cost declines the depreciation rate in the subsequent period also declines. The rate used takes into account the asset's cost, salvage or residual value, and estimated life.

The “sum-of-the-years = digits” method simply applies a fraction, the constant denominator of which is the sum of the years of estimated economic life and the numerator of which for each year is the remaining years of life, to the depreciable cost of the asset. For example, the fraction in year 1 of an asset with a five-year life would be 5/(5 + 4 + 3 + 2 + 1), or 5/15, or 332%. The method is simple and produces the desired accelerated deprecation result.

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