This lesson provides an in-depth understanding of depreciation, its purpose, and how to record and manage it effectively. By the end of this lesson, you will learn the importance of depreciation in managing a company’s financial statements, practical knowledge of recording and managing depreciation in a ledger, and how depreciation affects cash flow, profit and loss, and the balance sheet.
- What is Depreciation?
Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It represents the decrease in the value of an asset due to wear and tear, obsolescence, or other factors. Depreciation is recorded as a non-cash expense on the income statement, and it reduces the carrying value of an asset on the balance sheet.
- Why does Depreciation exist?
Depreciation exists for several reasons:
- It helps allocate the cost of an asset over its useful life, matching the expenses with the revenue generated from the asset.
- It provides a more accurate representation of an asset’s value on the balance sheet.
- It allows companies to claim tax deductions based on the depreciation expense, reducing taxable income.
- How to record Depreciation?
Depreciation is recorded as an expense on the income statement and reduces the carrying value of the asset on the balance sheet. The journal entry for recording depreciation includes a debit to Depreciation Expense and a credit to Accumulated Depreciation (a contra-asset account).
Example:
| Account | Debit | Credit |
| Depreciation Expense | $1,000 | |
| Accumulated Depreciation | $1,000 |
- Understanding the Depreciation Process
The depreciation process involves selecting an appropriate depreciation method, determining the asset’s useful life, and calculating the depreciation expense. Common depreciation methods include the Straight-Line Method, Double Declining Balance Method, and the Units of Production Method.
- Examples of Depreciation for Different Types of Assets
- Buildings: Straight-Line Method
- Machinery: Double Declining Balance Method
- Vehicles: Straight-Line Method or Double Declining Balance Method
- How does Depreciation affect Cash Flow?
Depreciation is a non-cash expense, meaning it does not directly impact cash flow. However, it does affect net income, which is a component of cash flow from operating activities. Since depreciation is a tax-deductible expense, it can reduce taxable income and, consequently, the amount of taxes paid, potentially resulting in a positive impact on cash flow.
- How does Depreciation affect Profit and Loss?
Depreciation is recorded as an expense on the income statement, reducing the company’s net income. By allocating the cost of an asset over its useful life, depreciation helps match expenses with the revenues generated from the asset, providing a more accurate representation of the company’s profitability.
- How does Depreciation affect Balance Sheet?
Depreciation reduces the carrying value of an asset on the balance sheet. As the depreciation expense is recorded, the Accumulated Depreciation account (a contra-asset account) increases, which in turn decreases the net book value of the asset.
| Account | Assets | Liabilities & Equity |
| Equipment | $10,000 | |
| Accumulated Depreciation | -$1,000 | |
| Net Book Value | $9,000 |
