Depreciation of Assets
Fixed assets, such as buildings and machinery, are often the largest purchases a company makes. Business owners have several choices when determining how to account for the cost of these purchases.
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Definition
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Depreciation refers to the allocation of a fixed asset's cost over its useful life. A fixed asset is tangible property the business will own for more than a year, such as buildings, furniture, fixtures, machinery and equipment.
Methods
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The four most common depreciation methods are straight line, double declining balance, sum of the years' digits and units of production. The straight line method steadily depreciates an asset over its useful life; units of production expenses an asset as it is consumed; and both double declining balance and sum of the years' digits record the asset's cost at an accelerated pace.
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Journal Entries
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Accountants expense the cost of an asset by debiting the income statement account "depreciation expense" and crediting the contra asset account "accumulated depreciation." This entry lowers net income on the income statement and decreases the value of the asset on the balance sheet summary.
Effect on Financial Statements
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Firms pay cash upfront to purchase an asset but spread the expense over the asset's useful life. As a result, depreciation expense on the income statement is a "non-cash" entry, and accountants must add it back to net income, along with any other non-cash items, to arrive at the actual cash flow for the month.
Tax Considerations
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Firms often depreciate assets differently for book and tax purposes. Business owners frequently choose to recognize depreciation at an accelerated pace to lessen their tax burden.
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References
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