How to Demonstrate Depreciation on a Trial Balance
Depreciation expense is the allocation of cost associated with the purchase of capital assets like machinery and real estate. A capital asset is an item purchased by a business that has an estimated life of more than one year. Instead of taking an expense on the item in the year purchased, the cost deduction is spread out over the useful life of the asset. The IRS has assigned an allowable tax-life to certain classes of assets. A trial balance should reflect an annual adjustment for depreciation expense; this adjustment is usually based on IRS guidelines for allowable depreciation expense deductions.
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Instructions
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Depreciation Entries in the Trial Balance
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Decide on the book depreciation method. Accountants usually use a straight-line method of accounting, which provides for substantially lower depreciation expense than allowable tax depreciation. This is because management may want to review the net profit of a business before the cost savings adjustments for accelerated depreciation are taken. Therefore, if a piece of machinery costs $10,000 and has a useful life of five years, the depreciation expense is shown as $2,000 for the current year.
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Make the trial balance depreciation entry. The accounting entry to demonstrate book depreciation is to debit depreciation expenses on the profit-and-loss statement and credit depreciation allowances in the balance sheet. For example, if the depreciation expense is for $2,000, the trial balance will show an expense for $2,000, and a contra-asset account in the balance sheet called depreciation allowance will show $2,000. A contra-asset account is a line item that allows the original cost of the asset to show on the books with an offsetting entry just below it that reflects the depreciation expense taken on the asset.
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3
Adjust the book entry for depreciation to reflect the tax depreciation. Since the depreciation shown on the trial balance is not based on tax depreciation, a year-end adjustment needs to be made to reflect tax depreciation instead of book depreciation. For example, if book depreciation shows $5,000, but tax depreciation is actually $7,500, a year-end adjusting entry must be made in the amount of $2,500 as follows: debit depreciation expense for the additional expense of $2,500 and credit depreciation allowance for $2,500 on the balance sheet.
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Tips & Warnings
In some cases, the tax law permits an acceleration of depreciation expense, but some companies may not want to record the accelerated depreciation on their books until the tax filing because the accelerated depreciation artificially reduces the company’s actual book-profit.
Consult with a CPA or tax expert regarding the best method to use for tax depreciation versus book depreciation. The tax depreciation method can substantially affect the taxable profit shown on a company’s tax return. Also remember to re-adjust tax depreciation back to book depreciation after the tax return is prepared,
