Depreciation seems to be very confusing to a lot of first year accountants. This doesn’t need to be a hard subject. Basically, depreciation is separating cost over time. It does not affect cash flow. For example if you buy a pencil and you use it for 2 years. First you would record the price you paid for the pencil let’s say that is 5 dollars (premium pencil). So your cash goes down 5 dollars the moment you purchase the pencil. But the useful life of the pencil you know will be at least 5 years. If you are trying to determine what detriment your organization has received due to the purchase of this pencil then you would need to divide the cost of the pencil over its useful life. In this case you would say that your company expensed $5/5 years = $1 per year of depreciation expense.
This example is not realistic due to the small dollar amount. Generally even if a pencil really is useful for 5 years a company would not go through the trouble of capitalizing the expense and depreciating it over time. But we can learn the concepts easier with small numbers.
So to continue with this example you would have yearly entries to make. The first entry will be for the purchase and then each year you would do an entry to show the detriment to your financial statements:
January 1st Year 1
Debit Fixed Asset (Pencil) $5.00
Credit Cash $5.00
To record the purchase of the Pencil
Notice that no expense accounts are affected by this transaction. We just removed cash and added an asset. So our Income Statement is not affected. Only our balance sheet has changed a liquid asset (cash) into a fixed asset (pencil).
December 31 year 1
Debit Depreciation Expense (Pencil) ` $1.00
Credit Accumulated Depreciation (Pencil) $1.00
To record 1 year of depreciation expense for the pencil.
Notice that now we have an expense account being affected (Depreciation Expense). Therefore only $1 of the $5 dollar purchase is reducing our income for the year. If we stop at this point and look at our balance sheet we would see the following:
Fixed Asset (Pencil) $5.00
Accumulated Depreciation (Pencil) -$1.00
Here we see that the net value of the pencil on our balance sheet is $4.00. This is also referred to as Net Book Value.
The depreciation expense method we are using here is a simple even number divided over the life of the asset. But in reality most companies do not use this method (straight line). Most companies will use at least 2 different methods. One method will be for reporting of taxes and another method will be for internal reporting. This may be referred to as different “books.” The tax book we usually use an accelerated depreciation method. This means that more depreciation will be taken in early years and less in later years. This has been a recent benefit that the United States government has provided for companies.
If a company can increase their depreciation expense earlier, then they can decrease their income and thus reduce their taxes. This may seem undesirable to an investor but remember that there is another method of depreciation used for reporting outside of taxes. So for example we could have $100 of depreciation expense for tax purposes and cause that we pay less taxes but then only have $50 of depreciation expense for our book reporting and show a higher income for that period.
This was just a quick beginner’s guide to basic information about depreciation. Further detail and research will be required to understand more complicated depreciation methods. But software is normally used to control a company that has many assets and many books to record them in.