Depreciation

Definition

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents the gradual decrease in the value of an asset due to wear and tear, age, and obsolescence. Depreciation is a crucial concept in financial accounting that affects various financial statements and reporting.

5 Must Know Facts For Your Next Test

1. Depreciation is used to systematically allocate the cost of a tangible asset over its useful life, reflecting the asset's gradual decline in value.
2. The amount of depreciation expense recorded each period is determined by the asset's cost, estimated useful life, and salvage value.
3. Depreciation is a non-cash expense that reduces the net income reported on the income statement, but it does not affect the company's cash flow.
4. Accumulated depreciation, the total amount of depreciation recorded over an asset's life, is reported as a contra-asset account on the balance sheet, reducing the asset's carrying value.
5. The choice of depreciation method, such as straight-line, declining balance, or units of production, can significantly impact a company's financial statements and tax liabilities.

Review Questions

• Explain how depreciation affects the preparation of the Income Statement, Statement of Owner's Equity, and Balance Sheet.
  • Depreciation is a key expense that is reported on the Income Statement, reducing the company's net income. The accumulated depreciation is then reflected as a contra-asset on the Balance Sheet, reducing the carrying value of the related long-term asset. Additionally, the depreciation expense impacts the Statement of Owner's Equity by reducing the company's retained earnings, as the net income is decreased by the depreciation charge.
• Describe the concepts and guidelines that affect the recording of depreciation as an adjusting entry.
  • The recording of depreciation as an adjusting entry is guided by several accounting principles and concepts. These include the matching principle, which requires that expenses be recognized in the same period as the related revenues, and the cost principle, which states that assets should be recorded at their historical cost. Additionally, the useful life and salvage value of the asset must be estimated, and the appropriate depreciation method must be selected, all of which impact the amount of depreciation expense recorded in each accounting period.
• Analyze how the accounting for depreciation is incorporated into the comprehensive accounting cycle for a business.
  • Depreciation is a critical component of the accounting cycle. At the end of each accounting period, the depreciation expense is calculated and recorded as an adjusting entry, which affects the Income Statement, Balance Sheet, and Statement of Owner's Equity. The accumulated depreciation is then updated on the Balance Sheet, and the depreciation expense is reflected on the Income Statement, ultimately impacting the company's net income and retained earnings. This cycle of recording, adjusting, and reporting depreciation is essential for accurately representing the financial position and performance of the business.

Related terms

Amortization: The process of allocating the cost of an intangible asset, such as a patent or software, over its useful life.

Impairment: The reduction in the carrying value of an asset due to events or circumstances that indicate the asset's value has declined below its book value.

Salvage Value: The estimated amount that an asset can be sold for at the end of its useful life, also known as the residual value.