The fixed assets acquired for the purpose of using them in the business operations are usually useful only for a limited period. The cost of these assets is allocated as expense over the years in which they are used. This gradual conversion of an asset into expense is termed as depreciation.
In simple words, we can say that the depreciation is the allocation of the cost of a fixed asset to the periods in which the benefit is obtained from the use of the asset. It is calculated on the original cost and should not be confused with the market value. Any decrease in the market value of the asset cannot be regarded as depreciation.
Let’s take an example to make the concept more clear. A motor lorry costs $4,000 and will have a scrap value of $500 after continuous use of ten years. It means that the cost of $3,500 ($4,000 – $500) is to be allocated as expense over ten years. If fixed installment method of depreciation is used, a cost of $350 is to be allocated as an expense by means of making an adjusting entry at the end of each year.
If this allocation is not made, the income statement will reflect higher income or lower loss. In other words, the decline in the value of the asset by way of depreciation results directly from its use in the process of generating revenue. In view of this, such loss should be charged against revenue.
The amount of depreciation charged on various assets is an expense of the business and on the other hand, it is a decrease in the value of that particular asset upon which depreciation has been charged. So depreciation has the following two effects on final accounts:
- It is an expense of the business, therefore; it will be recorded on the debit side of Profit and Loss Account.
- On the other hand, it is a decrease in the value of a particular asset, therefore; it will be deducted from that particular Asset Account in Balance Sheet.
The adjusting entry for depreciation expense is made by debiting depreciation expense and crediting accumulated depreciation. It is shown below:
The depreciation expense appears on the income statement like any other expense. The accumulated depreciation is a contra asset account and is shown as a deduction from the cost of the related asset in the balance sheet. Both the presentations are illustrated by the following example:
Make an adjusting entry for depreciation expense on December 31, 2016. How the furniture will be shown as a fixed asset on the balance sheet on December 31, 2016 and December 31, 2017.
Adjusting entry for depreciation on December 31, 2016:
The above adjusting entry will also be made at the end of the next nine years. After that period the furniture will be fully depreciated ($250 × 10 years = $2,500).
Partial balance sheet as at December 31, 2016:
Partial balance sheet as at December 31, 2017:
Balance in accumulated depreciation account at December 31, 2017: $250 + $250 = $500.