Depreciation is systematic allocation the cost of a fixed asset over its useful life. It is a way of matching the cost of a fixed asset with the revenue (or other economic benefits) it generates over its useful life. Without depreciation accounting, the entire cost of a fixed asset will be recognized in the year of purchase. This will give a misleading view of the profitability of the entity. The observation may be explained by way of an example.
Example
ABC LTD purchased a machine costing $1000 on 1st January 2001. It had a useful life of three years over which it generated annual sales of $800. ABC LTD’s annual costs during the three years were $300.
If ABC LTD expensed the entire cost of the fixed asset in the year of purchase, its income statement would present the following picture the end of the three years:
| Income Statement | 2001 | 2002 | 2003 |
|---|---|---|---|
|
|
$ |
$ |
$ |
|
Sales |
800 |
800 |
800 |
|
Cost of Sales |
(300) |
(300) |
(300) |
|
Fixed Asset Cost |
(1000) |
- |
- |
|
Net Profit (Loss) |
(500) |
500 |
500 |
As you can see, income statement of ABC LTD shows net loss in the first year even though it earned the same revenue as in the subsequent years. Conversely, no fixed asset will appear in ABC LTD’s balance sheet although it had earned revenue from the machine’s use through out its useful life of 3 years.
If ABC LTD, instead of charging the entire cost of fixed asset at once, depreciates the capital expenditure over its useful life, its income statement and balance sheet would present the following picture at the end of the three years:
| Income Statement | 2001 | 2002 | 2003 |
|---|---|---|---|
|
|
$ |
$ |
$ |
|
Sales |
800 |
800 |
800 |
|
Cost of Sales |
(300) |
(300) |
(300) |
|
Fixed Asset Cost |
(333.3) |
(333.3) |
(333.3) |
|
Net Profit (Loss) |
166.7 |
166.7 |
166.7 |
| Balance Sheet (Extract) | 2001 | 2002 | 2003 |
|---|---|---|---|
|
|
$ |
$ |
$ |
|
Fixed Assets |
1,000 |
1,000 |
1,000 |
|
Accumulated Depreciation |
(333.3) |
(333.3) |
(333.3) |
|
Net Book Value |
666.7 |
333.3 |
Nil |
As you can see, the process of relating cost of a fixed asset to the years in which the economic benefits from its use are realized creates a more balanced view of the profitability of the company. Hence, depreciation is an application of the matching principle whereby costs are matched to the accounting periods to which they relate rather than on the basis of payment.
Accounting Entry
Double entry involved in recording depreciation may be summarized as follows:
|
Debit |
Depreciation Expense (Income Statement) |
|
Credit |
Accumulated Depreciation (Balance Sheet) |
Every accounting period, depreciation of asset charged during the year is credited to the Accumulated Depreciation account until the asset is disposed. Accumulated depreciation is subtracted from the asset’s cost to arrive at the net book value that appears on the face of the balance sheet. Using the last example, following double entries will be recorded in respect of depreciation:
| Depreciation Expense Account | |||
|---|---|---|---|
|
Debit |
Credit |
||
|
2001 - Accumulated Depreciation |
$333.3 |
2001 - Income Statement |
$333.3 |
|
2002 - Accumulated Depreciation |
$333.3 |
2002 - Income Statement |
$333.3 |
|
2003 - Accumulated Depreciation |
$333.3 |
2003 - Income Statement |
$333.3 |
|
|
$1,000 |
|
$1,000 |
| Accumulated Depreciation Account | |||
|---|---|---|---|
|
Debit |
Credit |
||
|
2001 - Balance c/d |
$333.3 |
2001 - Depreciation Expense |
$333.3 |
|
|
$333.3 |
|
$333.3 |
|
|
|
Balance b/d |
$333.3 |
|
2002 - Balance c/d |
$666.6 |
2002 - Depreciation Expense |
$333.3 |
|
|
$666.6 |
|
$666.6 |
|
|
|
2003 - Balance b/d |
$666.6 |
|
2003 - Balance c/d |
$1,000 |
2003 - Depreciation Expense |
$333.4 |
|
|
$1,000 |
|
$1,000 |