Depreciation and Depreciation Expense

Below provides a discussion on the most popular questions relating to depreciation and depreciation expense. The following depreciation expense questions are discussed in this article.

“What is depreciation and depreciation expense”
“Why is depreciation charged”
“How is depreciation expense calculated”
“What are the deprecation methods”
“Is depreciation a fixed cost”
“Is depreciation an asset or liability”
“Is depreciation expense an operating expense”
“Does depreciation go on the Income Statement”
“Does depreciation affect cash flow”
“Why is depreciation not charged on land”
“When is depreciation a product cost”
“What is the depreciation accounting entry”
“Where is depreciation on Balance Sheet”
“When is deprecation entry recorded”
“How does depreciation expense affect financial statements”

Ok let’s get started by defining deprecation and deprecation expense.

“What is depreciation and depreciation expense”?
Depreciation in accounting reflects the reduction in value of a fixed asset.  Assets which have a useful life of over one year will go through the process of depreciation.  Moreover, current assets are expensed (IE fully depreciated) in the fiscal year in which they are purchased.  As a result, current assets become operating expenses immediately upon being purchased.

Depreciation expense, on the other hand, is a dollar amount or reduction in value assigned to a fixed asset or pool of fixed assets.  For example, if your accountant calculates $5,000 as the depreciation expense on office equipment, he/she is essentially estimating that the office equipment will reduce in value by $5,000 during the fiscal period. 

“Why is depreciation charged”?
As mentioned above, depreciation expense reflects the reduction in value of an asset that has a useful life of more than one year.  Office supplies such as a pack of photocopy paper has a useful life of less than one year and therefore 100% of the photocopy paper is expensed in the fiscal year in which it was purchased.  A computer system, on the other hand, has a useful life far beyond the fiscal year in which it was purchased.  As a result, the computer system must undergo the process of deprecation which assigns an estimated reduction or a depreciation expense in each year of the computer’s useful life.

“How is depreciation expense calculated”?
The method of depreciation selected by your accountant will dictate how depreciation expense is calculated.  If your accountant uses the straight line method of depreciation, the process is quite straight forward; no pun intended.  Below is an example of depreciation expense using the straight line method of depreciation. 

On January 1, assume your company purchases a corporate vehicle for $20,000.  Also assume your accountant suggests the vehicle has a useful life of 5 years, after which time, it will have a salvage value of zero.  Also assume the half year rule doesn’t apply and your company’s year end is December 31.  Using the straight line method of depreciation, depreciation expense per annum would be $4,000 ($20,000 less a salvage value of $0.00 then divide by the estimated useful life of the fixed asset of 5 years = $4,000).

“What are the deprecation methods”?
The methods of depreciation include the straight line method of depreciation, the units of production method of depreciation, declining balance method of depreciation and the sum of the years method of deprecation.  We are not going to explain each method of depreciation here.  Instead, in the near future team members at www.businessplanhut.com intend to write individual articles explaining each of the methods of depreciations.

“Is Depreciation a fixed cost”?
In accounting there are two types of costs; namely, variable costs and fixed costs.  Variable costs fluctuate with an increase or decrease in unit sales.  Fixed costs, on the other hand, do not fluctuate with an increase or decrease of unit sales.  As a result, depreciation expense is considered a fixed cost.  In other words, depreciation expense will not increase if you sold one more or one fewer unit of product.

“Is Depreciation an asset or liability”?
Deprecation and depreciation expense is not an asset nor is deprecation expense a liability.  The contra account, however, of deprecation expense is referred to as accumulated depreciation and appears under the fixed assets section of the balance sheet.  We will discuss this later on in greater detail.

“Is depreciation expense an operating expense”?
This question is asked quite frequently by business owners, managers and students studying for a business degree.  The simple answer is yes depreciation expense is an operating expense.

The confusion usually surfaces as a result of how depreciation expense can sometimes be presented on an income statement.  Furthermore, the income statement is generally prepared by subtracting the cost of goods sold (if any) and operating expenses from the companies revenues.  The resulting figure is referred to as “net earnings before deprecation and taxes”.  Then deprecation expense is subtracted of this total to arrive at net earnings before tax.  The mere fact that the depreciation expense is removed from the operating expenses is where the confusion begins.

Think of it this way.  You need all your fixed assets to successfully operate your business.  Since fixed assets depreciate, depreciation expense must be an operating expense.  You may need to re-read the previous sentence to fully comprehend the theory.  At any rate, depreciation expense is an operating expense.    

“Does depreciation go on the Income Statement”?
Yes, depreciation expense goes on the income statement.  Some accountants separate depreciation expense from the operating expenses while others simply place depreciation, for each of the fixed asset pools, under the operating expenses section.  Examples of depreciation expense accounts include, but not limited to, the following:

Depreciation expense office equipment
Depreciation expense office furniture
Depreciation expense vehicles
Depreciation expense buildings
Depreciation expense factory
Depreciation expense plant
Depreciation expense computer equipment
Depreciation expense production equipment

“Does depreciation expense affect cash flow”?
No, depreciation and depreciation expense does not affect cash flow.  Depreciation is a non cash expense.  A question often asked is this...  If depreciation expense is a non-cash expense, why then does it appear on the cash flow statement.  Folks, depreciation is a non cash expense and it will never appear on the cash flow statement.  Only revenues, costs, and expenditures requiring cash appear on the cash flow statement. 

If you fully understand the purchases of fixed assets and depreciation expense, you understand that the purchase of a fixed asset will go on the cash flow statement as soon as the fixed asset is purchased.  When the fixed asset is depreciated, it does not appear on the cash flow statement again.  That would be double dipping.

“Why is depreciation not charged on land”?
Land is a fixed asset and depreciation expense on land will never apply.  Why?  Since land is limited and the superior being is not making anymore of it, this fixed asset will never depreciate.  In fact, land will always remain the same value or, in most cases, appreciate in value.  The reason was stated in the above sentence, meaning land is a limited resource and is not being regenerated. 

“When is depreciation a product cost”?
This question relating to depreciation expense is one that is extremely confusing to many.  Depreciation is not a product cost nor is depreciation expense a cost of good sold, but rather depreciation expense attempts to reasonably reflect the reduction in value of a fixed asset. 

“What is the Depreciation accounting entry”?
Two accounts form the depreciation account entry which includes depreciation expense and accumulated depreciation.  The depreciation expense account appears on the income statement while the accumulated depreciation account appears on the balance sheet.

To better explain the depreciation accounting entry, let’s assume the following information.

-    Your company purchased a computer for $6,000.
-    The computer was purchased on January 1.
-    Your fiscal year end is December 31 of each year.
-    The useful life of the computer is estimated at 3 years.
-    The salvage value at the end of the useful life is zero.
-    The straight line method of depreciation is used by your accountant.
 
Using the above information, depreciation expense is calculated at $2,000 per fiscal year ($6,000 – $0.00 salvage value = $6,000 divided by 3 years estimated useful life of the computer = $2,000 depreciation expense per fiscal year). 

So the accounting entry, also referred to as a journal entry, for each of the three years of the useful life of the computer would be as follows:

Year 1:

Depreciation Expense on Computer          $2,000
             Accumulated Depreciation on Computer        $2,000

Year 2:

Depreciation Expense on Computer          $2,000
             Accumulated Depreciation on Computer        $2,000

Year 3:

Depreciation Expense on Computer          $2,000
             Accumulated Depreciation on Computer        $2,000

Assuming no other computer equipment is purchased within the next three years, depreciation expense relating to this computer equipment would be $2,000.

“Where is depreciation on Balance Sheet”?
Let’s use the above example to answer this question.  So assuming no other computer equipment will be purchased over the next three years, the values appearing on the balance sheet for the computer equipment would be as follows:

Fixed Asset Section of the Balance Sheet (year 1):

Computer Equipment               $6,000
Accumulated Depreciated        $2,000
Net book value of Computer    $4,000

Fixed Asset Section of the Balance Sheet (year 2):

Computer Equipment               $6,000
Accumulated Depreciated        $4,000
Net book value of Computer    $2,000

Fixed Asset Section of the Balance Sheet (year 3):

Computer Equipment               $6,000
Accumulated Depreciated        $6,000
Net book value of Computer    $ 0.00

“When is deprecation entry recorded”?
Depreciation expense can be recorded at anytime throughout the company’s fiscal period.  Non-profit organizations and profit seeking Corporations generally hold monthly board meetings.  During these meetings financial statements such as the income statement and balance sheet are usually discussed and reviewed.  In most cases, however, depreciation and depreciation expense does not appear on the financial statements.  That said, whether depreciation expense appears on monthly financial statements simply depends on the company’s business policies.

For smaller businesses and organizations, not having an internal finance department, depreciation expense is most often calculated by the accountant at the end of the company’s fiscal year.     

“How does depreciation expense affect financial statements”?

The three main financial statements are the income statement, the balance sheet and the cash flow statement.  Below summarizes the affects depreciation has on financial statements.

Again, depreciation attempts to estimate the reduction in value of a fixed asset.  The expense side of depreciation appears on the income statement as depreciation expense.  Depreciation expense increases corporate expenses and therefore reduces the company’s net earnings.

The depreciation expense appears on the balance sheet in the form of an account known as accumulated depreciation.  As the name implies, accumulated depreciation is the collection of an accumulation of depreciation expenses throughout the years.  The accumulated depreciation is subtracted from the historical cost of the fixed asset to reflect the amount the fixed assets reduced in value.   As a result, the affect on the balance sheet is simply that it reduces the value of the fixed asset and, hense, the total assets of the company. 

Depreciation has no affect on the cash flow statement since depreciation expense and accumulated depreciation does not appear on the cash flow statement.  Recall from above, depreciation is a non cash expense and therefore will never appear on the cash flow statement nor on the forecasted cash flow statement.

This concludes our discussion on depreciation and depreciation expense.  For additional articles on depreciation, depreciation expense or accumulated depreciation, you can use  our internal search function located at the top right of this page.