Depreciation is an expense, so it can be difficult to understand how it can affect the balance sheet. As a noncash expense, depreciation writes off the value of assets over time. Due to the matching principle, accountants prefer to write off the value of assets as they are used over the life of the asset. That write-down occurs on the balance sheet with the line items depreciation expense and the contra account, accumulated depreciation.
Cash and Noncash Transactions
Due to accrual accounting and several other accounting conventions used as a way to track transactions over time, there are two different types of transactions: cash and noncash. Depreciation is considered a noncash expense that is deducted from operating income; however, it also changes the value of assets on the balance sheet.
As an example, assume you purchased a car for your business. The car is expected to have a useful life of 5 years and a salvage value of $5,000 at the end of its useful life. The cost of the car is $20,000. Subtract the salvage value from the cost of the car and divide by the useful life for the annual depreciation expense. This is the amount that is deducted from assets at the end of each year. The calculation is $20,000 minus $5,000 divided by 5, or $3,000.
The balance sheet provides the reader with a value for total assets and shows how those assets were purchased, with either debt or equity. As the value of assets erodes from usage, the value is written off on the balance sheet. The contra-account for depreciation is accumulated depreciation. This is the account that holds the value of asset depreciation over time.
Effect of Depreciation on the Balance Sheet
When a company invests in depreciable assets such as machines and equipment, investors can expect to see an increase of assets on the balance sheet for that year. The following year, the asset is depreciated by the annual depreciation expense. In this example, the value of the asset is reduced by $3,000 which reduces the value of assets on the balance sheet by $3,000 and net income by $3,000.
Depreciation expense is the contra account that balances depreciation expense on the balance sheet. A contra account is needed to make a balancing entry on the balance sheet. On the balance sheet, depreciation expense decreases the value of assets and accumulated depreciation, the contra account for depreciation expense, holds this value so the effect of depreciation expense on the balance sheet is negative.