Companies purchase fixed assets to use in the operation of the business. The accountant capitalizes the fixed assets and depreciates them throughout the asset’s useful life. The accountant records a journal entry to recognize depreciation at the end of each period. The recorded depreciation affects several financial statements.
The income statement lists all of the revenues and subtracts the expenses to arrive at net income. As an asset depreciates, the accountant records a journal entry to debit Depreciation Expense and credit Accumulated Depreciation. The expenses listed on the income statement include depreciation expense. Depreciation expense reduces net income. The faster an asset depreciates, the lower net income will be during those years. The value of Depreciation Expense starts at zero each period.
The balance sheet calculates total assets, total liabilities and total owner’s equity. The total of the liabilities and owner’s equity equal the total assets. Accumulated Depreciation compiles the total of all the depreciation expense recorded since the asset was placed in service. Accumulated Depreciation is a contra asset account and behaves the opposite of asset accounts. The cost of the fixed asset minus the associated accumulated depreciation equals the book value of the asset. The balance sheet includes Accumulated Depreciation in the asset section and subtracts this amount from the asset value. The value in Accumulated Depreciation increases each period and remains on the balance sheet until the company sells the asset.
Statement of Cash Flows
Accountants preparing the statement of cash flows using the indirect method include the value of depreciation expense in the section Cash Flows from Operating Activities. The section Cash Flows from Operating Activities starts by listing the net income for the period. The accountant adds the noncash expenses, including depreciation expense, back to the net income. Adding the depreciation expense back to net income increases the total cash flows from operating activities.