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The accounting entry for depreciation

Source: https://www.accountingtools.com/articles/what-is-the-accounting-entry-for-
depreciation.html

April 13, 2013

The accounting for depreciation requires an ongoing series of entries to charge a fixed asset
to expense, and eventually to derecognize it. These entries are designed to reflect the
ongoing usage of fixed assets over time.

Depreciation is the gradual charging to expense of an asset's cost over its expected useful
life. The reason for using depreciation to gradually reduce the recorded cost of a fixed asset
is to recognize a portion of the asset's expense at the same time that the company records the
revenue that was generated by the fixed asset. Thus, if you charged the cost of an entire
fixed asset to expense in a single accounting period, but it kept generating revenues for years
into the future, this would be an improper accounting transaction under the matching
principle, because revenues are not being matched with related expenses.

In reality, revenues cannot always be directly associated with a specific fixed asset. Instead,
they can more easily be associated with an entire system of production or group of assets.

The journal entry for depreciation can be a simple entry designed to accommodate all types
of fixed assets, or it may be subdivided into separate entries for each type of fixed a sset.

The basic journal entry for depreciation is to debit the Depreciation Expense account (which
appears in the income statement) and credit the Accumulated Depreciation account (which
appears in the balance sheet as a contra account that reduces the amount of fixed assets).
Over time, the accumulated depreciation balance will continue to increase as more
depreciation is added to it, until such time as it equals the original cost of the asset. At that
time, you stop recording any depreciation expense, since the cost of the asset has now been
reduced to zero.

For example, ABC Company calculates that it should have $25,000 of depreciation expense
in the current month. The entry is:
Debit Credit

Depreciation expense 25,000

Accumulated depreciation 25,000

In the following month, ABC's controller decides to show a higher level of precision at the
expense account level, and instead elects to apportion the $25,000 of depreciation among
different expense accounts, so that each class of asset has a separate depreciation charge.
The entry is:

Debit Credit

Depreciation expense - Automobiles 4,000

Depreciation expense - Computer equipment 8,000

Depreciation expense - Furniture & fixtures 6,000

Depreciation expense - Office equipment 5,000

Depreciation expense - Software 2,000

Accumulated depreciation 25,000

Depreciation is considered an expense, but unlike most expenses, there is no related cash
outflow. This is because a company has a net cash outflow in the entire amount of the asset
when the asset was originally purchased, so there is no further cash-related activity. The one
exception is a capital lease, where the company records it as an asset when acquired, but
pays for the asset over time, under the terms of the associated lease agreement.

Finally, depreciation is not intended to reduce the cost of a fixed asset to its market value.
Market value may be substantially different, and may even increase over time. Instead,
depreciation is merely intended to gradually charge the cost of a fixed asset to expense over
its useful life.

Depreciation and a number of other accounting tasks make it inefficient for the accounting
department to properly track and account for fixed assets. They reduce this labor by us ing a
capitalization limit to restrict the number of expenditures that are classified as fixed assets.
Any expenditure for which the cost is equal to or more than the capitalization limit, and
which has a useful life spanning more than one accounting period (usually at least a year) is
classified as a fixed asset, and is then depreciated.
Accumulated depreciation
April 13, 2013

Accumulated depreciation is the total depreciation for a fixed asset that has been charged to
expense since that asset was acquired and made available for use. The accumulated
depreciation account is an asset account with a credit balance (also known as a contra asset
account); this means that it appears on the balance sheet as a reduction from the gross
amount of fixed assets reported.

The amount of accumulated depreciation for an asset will increase over time, as depreciation
continues to be charged against the asset. The original cost of the asset is known as its gross
cost, while the original cost of the asset, less the amount of accumulated depreciation and
any impairment, is known as its net cost or carrying amount.

The balance in the accumulated depreciation account will increase more quickly if a
business uses an accelerated depreciation methodology, since doing so charges more of an
asset's cost to expense during the earlier years of usage.

When the asset is eventually retired or sold, the amount in the accumulated depreciation
account relating to that asset is reversed, as is the original cost of the asset, thereby
eliminating all record of the asset from the company's balance sheet. If this derecognition
were not completed, a company would gradually build up a large amount of gross fixed asset
cost and accumulated depreciation on its balance sheet.

Calculating accumulated depreciation is a simple matter of running the depreciation


calculation for a fixed asset from its acquisition date to its disposition date. However, it is
useful to spot-check the calculation of the depreciation amounts that were recorded in the
general ledger over the life of the asset, to ensure that the same calculations were used to
record the underlying depreciation transaction.

For example, ABC International buys a machine for $100,000, which it records in the
Machinery fixed asset account. ABC estimates that the machine has a useful life of 10 years
and will have no salvage value, so it charges $10,000 to depreciation expense per year for 10
years. The annual entry, showing the credit to the accumulated depreciation account, is:
Debit Credit
Depreciation expense 10,000

Accumulated depreciation 10,000

After 10 years, ABC retires the machine, and records the following entry to purge both the
asset and its associated accumulated depreciation from its accounting records:

Debit Credit

Accumulated depreciation 100,000

Assets - Machinery 100,000


Overview of capital budgeting
May 17, 2017

Capital budgeting is the process of analyzing and ranking proposed projects to determine
which ones are deserving of an investment. The result is intended to be a high return on
invested funds.

There are three general methods for deciding which proposed projects should be ranked
higher than other projects, which are (in declining order of preference):

1. Throughput analysis. Determines the impact of an investment on the throughput of an entire


system.
2. Discounted cash flow analysis. Uses a discount rate to determine the present value of all
cash flows related to a proposed project. Tends to create improvements on a localized basis,
rather than for the entire system, and is subject to incorrect results if cash flow forecasts are
incorrect.
3. Payback analysis. Calculates how fast you can earn back your investment; is more of a
measure of risk reduction than of return on investment.

These capital budgeting decision points are outlined in the following sections.

Throughput Analysis

Under throughput analysis, the key concept is that an entire company acts as a single system,
which generates a profit. Under this concept, capital budgeting revolves around the
following logic:

1. Nearly all of the costs of the production system do not vary with individual sales; that is,
nearly every cost is an operating expense; therefore,
2. You need to maximize the throughput of the entire system in order to pay for the operating
expense; and
3. The only way to increase throughput is to maximize the throughput passing through the
bottleneck operation.

Consequently, you should give primary consideration to those capital budgeting proposals
that favorably impact the throughput passing through the bottleneck operation.
This does not mean that all other capital budgeting proposals will be rejected, since there are
a multitude of possible investments that can reduce costs elsewhere in a company, and which
are therefore worthy of consideration. However, throughput is more important than cost
reduction, since throughput has no theoretical upper limit, whereas costs can only be
reduced to zero. Given the greater ultimate impact on profits of throughput over cost
reduction, any non-bottleneck proposal is simply not as important.

Discounted Cash Flow Analysis

Any capital investment involves an initial cash outflow to pay for it, followed by a mix of
cash inflows in the form of revenue, or a decline in existing cash flows that are caused by
expense reductions. We can lay out this information in a spreadsheet to show all expected
cash flows over the useful life of an investment, and then apply a discount rate that reduces
the cash flows to what they would be worth at the present date. This calculation is known
as net present value. Net present value is the traditional approach to evaluating capital
proposals, since it is based on a single factor cash flows that can be used to judge any
proposal arriving from anywhere in a company.

For example, ABC Company is planning to acquire an asset that it expects will yield
positive cash flows for the next five years. Its cost of capital is 10%, which it uses as the
discount rate to construct the net present value of the project. The following table shows the
calculation:
Year Cash Flow 10% Discount Factor Present Value

0 -$500,000 1.0000 -$500,000

1 +130,000 0.9091 +118,183

2 +130,000 0.8265 +107,445

3 +130,000 0.7513 +97,669

4 +130,000 0.6830 +88,790


5 +130,000 0.6209 +80,717

Net Present Value -$7,196

The net present value of the proposed project is negative at the 10% discount rate, so ABC
should not invest in the project.

In the 10% Discount Factor column, the factor becomes smaller for periods further in the
future, because the discounted value of cash flows are reduced as they progress further from
the present day. The discount factor can be derived from the following formula:
Present value of a Future cash flow
future cash flow

= ----------------------------------------------------------------------------

(1 + Discount rate)squared by the number of periods of discounting

Payback Analysis

The simplest and least accurate evaluation technique is the payback method. This approach
is still heavily used, because it provides a very fast back of the envelope calculation of
how soon a company will earn back its investment. This means that it provides a rough
measure of how long a company will have its investment at risk, before earning back the
original amount expended. Thus, it is a rough measure of risk. There are two ways to
calculate the payback period, which are:

1. Simplified. Divide the total amount of an investment by the average resulting cash flow.
This approach can yield an incorrect assessment, because a proposal with cash flows skewed
far into the future can yield a payback period that differs substantially from when actual
payback occurs.
2. Manual calculation. Manually deduct the forecasted positive cash flows from the initial
investment amount, from Year 1 forward, until the investment is paid back. This method is
slower to calculate, but ensures a higher degree of accuracy.
For example, ABC Company has received a proposal from a manager, asking to spend
$1,500,000 on equipment that will result in cash inflows in accordance with the following
table:
Year Cash Flow

1 +$150,000

2 +150,000

3 +200,000

4 +600,000

5 +900,000

The total cash flows over the five-year period are projected to be $2,000,000, which is an
average of $400,000 per year. When divided into the $1,500,000 original investment, this
results in a payback period of 3.75 years. However, the briefest perusal of the projected c ash
flows reveals that the flows are heavily weighted toward the far end of the time period, so
the results of this calculation cannot be correct.

Instead, the cost accountant runs the calculation year by year, deducting the cash flows in
each successive year from the remaining investment. The results of this calculation are:
Year Cash Flow Net Invested Cash

0 -$1,500,000

1 +$150,000 -1,350,000

2 +150,000 -1,200,000

3 +200,000 -1,000,000

4 +600,000 -400,000

5 +900,000 0

The table indicates that the real payback period is located somewhere between Year 4 and
Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there
is $900,000 of cash flow projected for Year 5. The cost accountant assumes the same
monthly amount of cash flow in Year 5, which means that he can estimate final payback as
being just short of 4.5 years.

The payback method is not overly accurate, does not provide any estimate of how profitable
a project may be, and does not take account of the time value of money. Nonetheless, its
extreme simplicity makes it a perennial favorite in many companies.