27/10/2015

AccountingforDepreciationExplanationandIllustrativeExample

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DoubleEntryAccounting
AccountingforSales
AccountingforPurchases
AccountingforCashTransactions
AccountingforInventory
AccountingforFixedAssets
IntroductiontoFixedAssets
CapitalandRevenueExpenditure
AccountingforDepreciation
TypesofDepreciationMethods
StraightLine
DecliningBalance

Depreciation
Depreciation is systematic allocation the cost of a fixed asset over its useful life. It is a
wayofmatchingthecostofafixedassetwiththerevenue(orothereconomicbenefits)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
profitabilityoftheentity.Theobservationmaybeexplainedbywayofanexample.

Example
ABCLTDpurchasedamachinecosting$1000on1stJanuary2001.Ithadausefullifeof
threeyearsoverwhichitgeneratedannualsalesof$800.ABCLTD'sannualcostsduring
thethreeyearswere$300.
If ABC LTD expensed the entire cost of the fixed asset in the year of purchase, its
incomestatementwouldpresentthefollowingpicturetheendofthethreeyears:
IncomeStatement

2001

UnitsofProduction
Sumofyears'digits
AccountingForDisposals

AccrualsandPrepayments
ReceivablesandPayables
Accountingfordividends&interest
BankReconciliation
Trialbalance
RatioAnalysis

2002

$
Sales
CostofSales

2003

800

800

800

(300)

(300)

(300)

FixedAssetCost

(1000)

NetProfit(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'susethroughoutitsusefullifeof3years.
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
presentthefollowingpictureattheendofthethreeyears:
IncomeStatement

2001

2002

$
Sales

2003

800

800

800

(300)

(300)

(300)

FixedAssetCost

(333.3)

(333.3)

(333.3)

NetProfit(Loss)

166.7

166.7

166.7

CostofSales

BalanceSheet(Extract)

FixedAssets
AccumulatedDepreciation
NetBookValue

2001

2002

2003
$

1,000

1,000

1,000

(333.3)

(666.7)

(1,000)

666.7

333.3

Nill

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
principlewherebycostsarematchedtotheaccountingperiodstowhichtheyrelaterather
thanonthebasisofpayment.

AccountingEntry
Doubleentryinvolvedinrecodingdepreciationmaybesummarizedasfollows:
Debit

DepreciationExpense(IncomeStatement)
Credit

AccumulatedDepreciation(BalanceSheet)

AskaQuestion

Every accounting period, depreciation of asset charged during the year is credited to the
AccumulatedDepreciationaccountuntiltheassetisdisposed.Accumulateddepreciation
issubtractedfromtheasset'scosttoarriveatthenetbookvaluethatappearsontheface
ofthebalancesheet.Using the last example, following double entries will be recorded in
respectofdepreciation:

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27/10/2015

AccountingforDepreciationExplanationandIllustrativeExample
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DepreciationExpenseAccount
Debit

Credit

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2001

AccumulatedDepreciation

333.3

2001

IncomeStatement

333.3

2002

AccumulatedDepreciation

333.3

2002

IncomeStatement

333.3

2003

AccumulatedDepreciation

333.4

2003

IncomeStatement

333.4

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AccumulatedDepreciationAccount
Debit
2001

Balancec/d

2002

Balancec/d

Credit

333.3

2001

DepreciationExpense

2002

Balanceb/d

333.3

2002

DepreciationExpense

333.3

333.3
666.6

333.3

666.6
2003

Balancec/d

1000

333.3

666.6

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16

2003

Balanceb/d

666.6

2003

DepreciationExpense

333.4

1000

1000

28

69

84.8K

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UnitsofProduction
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Jointhediscussion
Joe 2yearsago

Lookslike166.7isshowingasalosswhenitshouldbeaprofitinthedepreciationexampleabove
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AccountingSimplified

Mod >Joe

2yearsago

ThanksJoe,wehavecorrectedtheaboveerror.Weappreciateyourinputinthisregard.
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PrarthnaBaranwal ayearago

veryhelpful:)

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