Introduction to Depreciation
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Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks are examples of assets that will last for more than one year, but will not last indefinitely. During each accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion being used up is reported as Depreciation Expense on the income statement. In effect depreciation is the transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the asset's life.
The calculation and reporting of depreciation is based upon two accounting principles:
- Cost principle. This principle requires that the Depreciation Expense reported on the income statement, and the asset amount that is reported on the balance sheet, should be based on the historical (original) cost of the asset. (The amounts should not be based on the cost to replace the asset, or on the current market value of the asset, etc.)
- Matching principle. This principle requires that the asset's cost be allocated to Depreciation Expense over the life of the asset. In effect the cost of the asset is divided up with some of the cost being reported on each of the income statements issued during the life of the asset. By assigning a portion of the asset's cost to various income statements, the accountant is matching a portion of the asset's cost with each period in which the asset is used. Hopefully this also means that the asset's cost is being matched with the revenues earned by using the asset.
There are several depreciation methods allowed for achieving the matching principle. The depreciation methods can be grouped into two categories: straight-line depreciation and accelerated depreciation.
The assets mentioned above are often referred to as fixed assets, plant assets, depreciable assets, constructed assets, and property, plant and equipment. It is important to note that the asset land is not depreciated, because land is assumed to last indefinitely.
Book vs. Tax Depreciation
AccountingCoach.com's discussion of depreciation is limited to the depreciation entered into the company's general ledger (or books) and reported on the company's financial statements. These amounts are based on accounting principles. The amounts resulting from the accounting principles are often different from the amounts based on the Internal Revenue Service code and regulations. Hence the depreciation on the financial statements will likely be legitimately different from the depreciation on the company's tax returns. [To learn about the depreciation for income tax purposes, you should review the Internal Revenue Service publications (available via the Internet) and/or consult a tax professional.]
Book Depreciation Illustrated
To illustrate depreciation used in the accounting records and on the financial statements, let's assume the following facts:
- On July 1, 2016 a company purchases equipment having a cost of $10,500.
- The company estimates that the equipment will have a useful life of 5 years.
- At the end of its useful life, the company expects to sell the equipment for $500.
- The company wants the depreciation to be reported evenly over the 5-year life.
Calculation of Straight-line Depreciation
The most common method of depreciating assets for financial statement purposes (as opposed to the method used for income tax purposes) is the straight-line method. Under this depreciation method, the depreciation for each full year is the same amount.
The depreciation expense for a full year when computed under the straight-line method is illustrated here:
If a company's accounting year ends on December 31, the company will report the depreciation expense on the company's income statement as shown in the following depreciation schedule:
The actual cash paid by the company for this equipment will occur as follows:
As you can see, the company paid $10,500 in 2016, but the 2016 income statement reports Depreciation Expense of only $1,000. (Because the asset was acquired on July 1, 2016, only half of the annual depreciation expense amount is recorded in 2016 and 2021.) In each of the years 2017 through 2020 the company's income statements will report $2,000 of Depreciation Expense, thereby matching $2,000 of Depreciation Expense with the revenues earned in each of those years. However, the company will not pay out any cash for this expense during those years. The company's net income before income taxes will be reduced in each of the years 2017 through 2020 by $2,000—but the Cash account will not be reduced. This explains why Depreciation Expense is sometimes referred to as a noncash expense.
Journal Entries For Depreciation
The depreciation for the financial statements is entered into the accounts via a general journal entry. Assuming that the company prepares only annual financial statements the journal entries can be prepared as of the last day of each year:
If monthly financial statements were prepared, 1/12 of the annual amounts would be entered monthly.
Note that the account credited in the journal entries is not the asset account Equipment. Instead, the credit is entered in the contra asset account Accumulated Depreciation. The use of this contra account will allow the asset Equipment to continue to report the equipment's cost, while also reporting in the account Accumulated Depreciation the amount that has been charged to Depreciation Expense since the asset was acquired. For example, as of December 31, 2017 the Equipment account will have a debit balance of $10,500. On the same day, the account Accumulated Depreciation will have a credit balance of $3,000. In T-account form, it looks like this:
The $10,500 debit balance in Equipment minus the $3,000 credit balance in Accumulated Depreciation equals $7,500. This net amount of $7,500 is referred to as the book value or as the carrying value of the equipment.