As your equipment ages and deteriorates, your accounting has to reflect that loss of value. Every month that your assets depreciate, you report the depreciation expense on your income statement. You also report depreciation on your balance sheet but not as a liability.
You record depreciation expense on the income statement and record accumulated depreciation as a contra asset account on the balance sheet. Accumulated depreciation accounts are not liability accounts.
Most fixed assets, such as buildings, trucks, factory equipment and office furniture, deteriorate over time. If you buy $10,000 worth of computer equipment, you record it in your accounting journal as a $10,000 asset. Over time, as the tech ages and becomes obsolete, it loses value. Depreciation is how you record the loss.
- Depreciation has no connection with the price for which you could sell an asset.
- Land is a fixed asset that doesn't depreciate.
Recording depreciation gives a better idea of what your aging assets are worth than just writing down the purchase price. It's also a tax write-off, as you can claim depreciation as a deduction.
Depreciation adds up over time. If your equipment depreciated 10% a year, after six years you'd have an accumulated depreciation of 60% of the original cost. There are three factors that determine the accumulated depreciation formula for a given asset:
- Useful life: An office copier, for example, might last only five years. You calculate depreciation so that at the end of five years, you've depreciated 100% of the cost. The accumulated depreciation formula would be different for a building with a useful life of 30 years.
- Salvage value: Suppose you have a piece of construction equipment with a useful life of 10 years. At the end of that time, you can still sell it for a salvage value of, say, 10% of the original cost. Over 10 years you'd depreciate 90% of the asset cost rather than 100%.
- Depreciation method: A straight-line method assumes you deduct the same amount every year: If an asset has a 20-year useful life, you'd depreciate it 5% a year. At the end of 10 years, accumulated depreciation would equal 50%. Other methods allow you to accelerate depreciation so it accumulates quicker.
Your choice of depreciation method and accumulated depreciation formula affects the depreciation write-off on your taxes, so it's important to give this some thought.
Each month, you record the appropriate percentage of deprecation in your accounting journals. If, say, you have an $80,000 asset that depreciates $500 a month, you'd record $500 in the depreciation expense account and the same amount in the accumulated depreciation account.
Rather than undergo the excruciating number crunching to depreciate each individual fixed asset, you can simply make one entry for the total depreciation on all your fixed assets. Alternatively, you can break it down and depreciate furniture, vehicles and computers in separate journal entries.
When you make out your financial statements for a month, quarter or year, you report depreciation as an expense on the income statement. If, say, your fixed assets depreciate $3,400 in January, you record that expense and subtract it from your income with other expenses. Even though you haven't spent any money on depreciation, it reduces your net income.
You do not report depreciation on the cash flow statement. As no cash changes hands, depreciation doesn't affect cash flow.
If you've wondered whether depreciation is an asset or a liability on the balance sheet, it's an asset — specifically, a contra asset account — a negative asset used to reduce the value of other accounts. If you have fixed assets worth $1.2 million and accumulated depreciation of $350,000, that reduces the value of the fixed asset account to $850,000.
For an accumulated depreciation balance sheet example, assume that at the end of the last quarter, you have $87,500 in the contra account. This quarter, you run up a depreciation expense of $9,000. At the end of the quarter, you add that to accumulated depreciation for a new total of $96,500.