Depreciation is a noncash transaction. It's a write-off to net income that allows businesses to lower their tax liability. The more net income is adjusted downward, the less a company has to pay in taxes. Even though deprecation is a noncash transaction, it does have a real effect on the financial statements and what's reported on the income statement and balance sheet. If the depreciation expense is understated, it affects both of these statements in two similar ways.

Step 1.

Obtain the chart of accounts, which contains data for depreciation expense, net income and retained earnings. Depreciation expense and net income are both net income line items. Retained earnings is a balance sheet line item.

Step 2.

Identify the extent of the understatement. That is, determine by what amount the depreciation expense is understated on the income statement. For this example, assume the understatement is $5,000.

Step 3.

Adjust depreciation expense upward by the amount. This is a debit to depreciation expense and a credit to accumulated depreciation. Accumulated depreciation is the contra account for depreciation expense.

Step 4.

Increase retained earnings. An understatement of depreciation causes retained earnings to be overstated. Your final adjustment is an increase to retained earnings for the understated amount. In this example, the adjustment is for $5,000.