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: 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. Assumptions Calculation of Straight-line Depreciation 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 2010, but the 2010 income statement reports Depreciation Expense of only $1,000. (Because the asset was acquired on July 1, 2010, only half of the annual depreciation expense amount is recorded in 2010 and 2015.) In each of the years 2011 through 2014 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 2011 through 2014 by $2,000—but the Cash account will not be reduced. This explains why Depreciation Expense is sometimes referred to as a noncash expense. 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, 2011 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. Examples of Estimates The calculation of depreciation shown above included two estimates: Changes in Estimates Whenever estimates are used in accounting, it is possible they will change as time moves forward. For example, a company bought a machine for $14,000 on January 1, 2006. At the time it was estimated to have no salvage value at the end of its useful life estimated to be 7 years. The company used straight-line depreciation. In 2010 the company realizes that technology will cause the machine to be obsolete by December 31, 2011 and there will be no salvage value at that time. Instead of the original useful life of 7 years, the company now estimates a total useful life of only 6 years (January 1, 2006 through December 31, 2011). This change in the estimated useful life affects only the current and future years. In other words, in this example the depreciation for 2010 and 2011 will be affected. The depreciation already reported for the years 2006, 2007, 2008, and 2009 cannot be changed. Any amount not depreciated as of December 31, 2009 will have to be depreciated over the years 2010 and 2011. Let's first calculate the straight-line depreciation using the estimates in January 2006: In the T-accounts we can see the cost of the Equipment $14,000 and the Accumulated Depreciation of $8,000 as of December 31, 2009: These accounts show that $6,000 ($14,000 – $8,000) remains on the books at December 31, 2009 and there are only two years remaining (2010 and 2011) in which to depreciate the remaining $6,000. The remaining $6,000 will be divided by the 2 years remaining and will result in $3,000 of depreciation in each of the years 2010 and 2011. In general journal format the entries will be: At the end of 2011 the Accumulated Depreciation account will look like this: Note that the depreciation amounts recorded in the years 2009 and before were not changed. What Is It? Accelerated depreciation is an alternative to the straight-line depreciation method. Compared to the straight-line method, accelerated depreciation methods provide for more depreciation in the early years of an asset's life but then less depreciation in the later years. Under any depreciation method, the maximum depreciation during the life of an asset is limited to the cost of the asset. The difference in depreciation methods involves when you will report the depreciation. It's a matter of timing. Again, the total depreciation during the life of the asset is the same regardless of the depreciation method used. As stated earlier, most companies use the straight-line method of depreciation for their financial statements. It is easy to compute and to understand. With straight-line depreciation the company will have the same amount of depreciation in each of the years of the asset's life. Accelerated depreciation will mean larger Depreciation Expense in the early years of the asset's life and then smaller Depreciation Expense in the later years. This larger expense in the earlier years will mean the company will report less profits in the earlier years of an asset's life (and greater profits in later years). Generally this is not appealing to most companies. As a result most companies will opt for the straight-line depreciation for their financial statements. However, using an accelerated depreciation method on the company's income tax returns is very appealing. Higher depreciation in the early years of the asset means immediate income tax savings. Smaller depreciation in later years is far into the future. Generally, it is better to take the income tax savings sooner rather than later. Fortunately a company is permitted to use straight-line depreciation on its financial statements and at the same time it can use accelerated depreciation on its income tax returns. Various Accelerated Depreciation Methods There are various methods of accelerated depreciation. Here are some of them: To learn more about these accelerated depreciation methods, refer to an Intermediate Accounting textbook. If you wish to use accelerated depreciation on your income tax return, refer to the Internal Revenue Service publications and/or consult with a tax professional.Introduction to Depreciation
Book Depreciation Illustrated
To illustrate depreciation used in the accounting records and on the financial statements, let's assume the following facts:
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.Cost of the asset $10,500 Less: Expected salvage value – 500 Depreciable Cost (amount to be depreciated over the estimated useful life) $10,000 Years of estimated useful life 5 Depreciation Expense per year $ 2,000 Depreciation Expense: Cash Paid: Journal Entries For Depreciation
Date Account Name Debit Credit December 31, 2010 Depreciation Expense 1,000 Accumulated Depreciation 1,000 December 31, 2011 Depreciation Expense 2,000 Accumulated Depreciation 2,000 December 31, 2012 Depreciation Expense 2,000 Accumulated Depreciation 2,000 December 31, 2013 Depreciation Expense 2,000 Accumulated Depreciation 2,000 December 31, 2014 Depreciation Expense 2,000 Accumulated Depreciation 2,000 December 31, 2015 Depreciation Expense 1,000 Accumulated Depreciation 1,000 Debit
Increases an assetCredit
Decreases an assetJuly 1, 2010 ENTRY 10,500 Debit
Decreases a contra assetCredit
Increases a contra asset1,000 ENTRY Dec. 31, 2010 2,000 ENTRY Dec. 31, 2011 3,000 Balance Dec. 31, 2011 Use of Estimates
Cost of the asset $14,000 Less: Expected salvage value – 0 Depreciable Cost (amount to be depreciated over the estimated useful life) $14,000 Years of estimated useful life 7 Depreciation Expense per year $ 2,000 Debit
Increases an assetCredit
Decreases an assetJan. 1, 2006 ENTRY 14,000 Debit
Decreases a contra assetCredit
Increases a contra asset2,000 ENTRY Dec. 31, 2006 2,000 ENTRY Dec. 31, 2007 2,000 ENTRY Dec. 31, 2008 2,000 ENTRY Dec. 31, 2009 8,000 Balance Dec. 31, 2009 Date Account Name Debit Credit December 31, 2010 Depreciation Expense 3,000 Accumulated Depreciation 3,000 December 31, 2011 Depreciation Expense 3,000 Accumulated Depreciation 3,000 Debit
Decreases a contra assetCredit
Increases a contra asset2,000 ENTRY Dec. 31, 2006 2,000 ENTRY Dec. 31, 2007 2,000 ENTRY Dec. 31, 2008 2,000 ENTRY Dec. 31, 2009 3,000 ENTRY Dec. 31, 2010 3,000 ENTRY Dec. 31, 2011 14,000 Balance Dec. 31, 2011 Accelerated Depreciation
Depreciation
Posted in: 
0 comments:
Post a Comment