Accounting treatment of depreciation
Once depreciation has been calculated using an appropriate method, it must be brought to books. As stated earlier, the accounting entries for depreciation are generally made at the end of each financial year. A new account called depreciation account, or more appropriately depreciation expense account, is opened in the books. This account is debited by the amount of depreciation to be provided for the year and the fixed asset account concerned is credited by same amount.
The effect of this entry is that depreciation expense account shows the amount of expense for the year while the fixed asset account shows a reduced balance. The depreciation expense account, being a nominal account, is closed at the end of each financial year by transferring its balance to the profit and loss account.
ABC company bought a motor vehicle for $75,000 on January 1, 2016. He plans to provide depreciation at 20% per year, using the reducing installment method. Show the following accounts in his ledger for 2016, 2017, and 2018.
- Motor vehicle account
- Depreciation account
- Relevant portion of profit and loss account
Step 1 : Calculation of depreciation for the year 2016, 2017 and 2018.
Book value (original cost for the first year) at the beginning of the year 2016: $75,000
Depreciation for the year 2016: $75,000 × 0.2 = $15,000
Book value at the beginning of the year 2017: $75,000 – $15,000 = $50,000
Depreciation for the year 2017: $50,000 × 0.2 = $10,000
Book value at the beginning of the year 2018: $50,000 – $10,000 = $40,000
Depreciation for the year 2018: $40,000 × 0.2 = $8,000
Step 2: Prepare the ledger accounts
At the end of all three years, the depreciation would appear on debit side of profit of loss account as an expense. It is shown below: