Depreciation Methods In accounting,depreciationis the process of allocating the cost of a tangible manmade asset used in the operations of the business over time. The recording of depreciation removes a portion of the asset's cost and reclassifies it as depreciation expense. Important: Depreciation expense doesnotresult in a cash outflow.In addition, depreciation expense doesnotrepresent a decrease in the fair market value of the asset - rather, it represents the using up of the asset's cost. Accounting equation effect:As an asset is depreciated, the company's total assets will decrease along with its total stockholders' equity. The decrease in total stockholders' equity is due to the recording of depreciation expense. As expenses increase, net income decreases. As net income decreases, total stockholders' equity decreases. When recording depreciation, companies do not decrease the asset account directly - instead, a contra-assetaccount called "Accumulated Depreciation" is increased. A contra-asset is an account whose balance is reported on the asset side of the balance sheet, but as the contra-asset account goes up, total assets go down.Whereas regular assets have a normal debit account balance, a contra-asset has a normal credit balance. Contra-asset accounts, like "Accumulated Depreciation", are linked to another regular balance sheet account. In this case, the "Accumulated Depreciation" account is linked to the asset account it is associated with. For example, the "Equipment" account is linked to the contra-asset account "Accumulated Depreciation - Equipment". As the "Accumulated Depreciation" account balance goes up, total assets go down. The "net" amount between the asset account balance and its related accumulated depreciation account balance represents theunusedcost of the asset remaining at year-end.This amount is often referred to as "book value" or "carrying value". Example: Presentation of Accumulated Depreciation on the Balance Sheet Assume a machine has an original cost of $100,000 and, by the end of 20X4, $40,000 of the machine's cost has been used up (depreciated).The asset'sbook valuewould be represented in the long-term asset section of the balance sheet as follows: Long-term Assets: Machine$100,000 Less: Accumulated Depreciation(40,000) Book Value (or carrying value)$ 60,000 or, alternatively, only thenetamount may be shown as follows: Long-term Assets: Machine(net of accumulated depreciation) $60,000 Regardless of which balance sheet presentation is shown, the $60,000 book value amount would be added to all of the other asset balances in order to determine total assets.
The advantage to the first presentation above is that, by comparing the two amounts, one can get a sense of how "used up" an asset is.Assets that are nearing the end of their useful life will likely need to be replaced in the near future.Replacing assets will require the using up of economic resources. Knowing this information may be useful to decision-makers. Companies who choose to present their long-term asset balance at only thenetamount should disclose in the notes to their financial statements the split between the cost balance and the accumulated depreciation balance.
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