Accounting Treatment of Depreciation

Depreciation is the systematic distribution of a fixed asset’s cost over its useful life. It is a method of matching the cost of a fixed asset with the income (or other economic advantages) it generates over the course of its useful life. Without depreciation accounting, a fixed asset’s complete cost is recorded in the year of acquisition. This will convey an inaccurate picture of the entity’s profitability.

What is Depreciation ?

Depreciation is defined in accounting as the systematic lowering of the reported cost of a fixed asset until the asset’s value is zero or inconsequential. Buildings, furniture, office equipment, machinery, and so on are examples of fixed assets. The land is the only exception that cannot be depreciated because its value increases over time. Depreciation allows us to apply the fixed asset’s cost percentage to the income it generates. This is required under the matching principle because revenues and related costs are recorded in the accounting period when the asset is in use. 

Accounting Treatment of Depreciation

After computing depreciation using an appropriate method, it must be recorded. Depreciation accounting entries are typically made at the conclusion of each financial year. In the books, a new account called the depreciation account, or more accurately, the depreciation expenditure account, is created. The amount of depreciation to be recorded for the year is debited to this account. In addition, the fixed asset account is credited by the same amount. As a result of this input, the depreciation expenditure account displays the total spending for the year, but the fixed asset account shows a lower balance. Because it is a nominal account, the depreciation expenditure account is closed at the conclusion of each financial year by moving its amount to the profit and loss account.

Example

On January 1, 2001, ABC LTD paid Rs1000 for a machine. It had a three-year useful life and made Rs800 in yearly sales. ABC LTD’s yearly expenses totalled Rs300 over the course of three years

If ABC LTD expensed the whole cost of the fixed asset in the year of purchase, its income statement at the end of three years would look like this:

As you can see, ABC LTD’s income statement shows a net loss in the first year despite earning the same revenue as in subsequent years. In contrast, despite earning money from the machine’s use during its three-year useful life, no fixed asset will appear on ABC LTD’s balance sheet.

If ABC LTD, instead of charging the whole cost of a fixed asset at once, depreciates the capital investment over its useful life, its income statement and balance sheet at the end of three years would look like this:

As you can see, relating the cost of a fixed asset to the years in which the economic benefits from its use are realised creates a more balanced view of the company’s profitability. Depreciation is thus an application of the matching principle, in which expenditures are matched to the accounting periods to which they pertain rather than on the basis of payment.

Treatment of Depreciation in Final Account

• When depreciation is included in the trial balance, it is considered an expense and is recorded on the negative side of the Profit and Loss Account. In this situation, no more adjustments are necessary.
• When depreciation is issued outside of the trial balance, it is considered as an adjustment and is posted twice to conform with the norms of the double-entry bookkeeping system. First, the amount of depreciation will be represented as an expenditure on the debit side of the Profit and Loss Account, and the amount of depreciation will be deducted from the related assets on the assets side of the Balance Sheet.

Conclusion 

Without depreciation accounting, a fixed asset’s complete cost is recorded in the year of acquisition. Depreciation is defined in accounting as the systematic lowering of the reported cost of a fixed asset until the asset’s value is zero or inconsequential. In the books, a new account called the depreciation account, or more accurately, the depreciation expenditure account, is created. The amount of depreciation to be supplied for the year is deducted from this account. As a result of this input, the depreciation expenditure account displays the total spending for the year, but the fixed asset account shows a lower balance. Since it is a nominal account, the depreciation expenditure account is closed at the conclusion of each financial year by moving its amount to the profit and loss account.