Depreciation is recorded in the books of accounts to recognise the current accounting period’s allocation of the cost of a depreciable tangible asset. Depreciation expense is charged to the Profit and Loss Account or Income Statement because it represents the cost of using the asset during the accounting period.
The accounting treatment of depreciation may be made either by charging depreciation directly to the relevant asset account or by maintaining a separate Accumulated Depreciation Account.
Depreciation Charged Directly to the Asset Account
Under the direct method, depreciation expense is charged directly against the relevant fixed asset. The accounting entry is:
Depreciation Expense A/c Dr.
To Fixed Asset A/c
The Depreciation Expense Account is debited because depreciation is an expense of the accounting period. The relevant Fixed Asset Account is credited because the carrying amount of the asset is reduced by the depreciation charged.
Under this method, the value of the fixed asset shown in the Balance Sheet decreases every year as depreciation is recorded. Therefore, the original historical cost of the asset is not separately preserved in the asset account after depreciation has been directly deducted.
For example, if depreciation of ₹10,000 is charged on equipment, the accounting entry will be:
Depreciation Expense A/c Dr. ₹10,000
To Equipment A/c ₹10,000
The equipment account is directly reduced by ₹10,000.
Depreciation through Accumulated Depreciation Account
Alternatively, depreciation may be recorded through a separate Accumulated Depreciation Account. Under this method, the original cost of the fixed asset remains recorded in the asset account, while the total depreciation charged over time is accumulated in a separate account.
The accounting entry is:
Depreciation Expense A/c Dr.
To Accumulated Depreciation A/c
The Depreciation Expense Account is debited because depreciation is recognised as an expense in the Income Statement. The Accumulated Depreciation Account is credited to record the cumulative depreciation associated with the fixed asset.
For example, if depreciation of ₹10,000 is charged on machinery, the entry will be:
Depreciation Expense A/c Dr. ₹10,000
To Accumulated Depreciation A/c ₹10,000
The original cost of machinery remains unchanged in the Machinery Account. The depreciation is separately accumulated in the Accumulated Depreciation Account.
Accumulated Depreciation as a Contra-Account
The Accumulated Depreciation Account is a contra-account associated with a fixed asset. It shows a negative amount against the related asset in the Balance Sheet and reduces the carrying amount of that asset.
For example, suppose machinery has a historical cost of ₹1,00,000 and accumulated depreciation of ₹30,000. The Balance Sheet presentation will reflect a carrying amount of ₹70,000.
Historical Cost of Machinery = ₹1,00,000
Less: Accumulated Depreciation = ₹30,000
Carrying Amount or Net Book Value = ₹70,000
Showing accumulated depreciation separately helps preserve the historical cost of the fixed asset while separately disclosing the total depreciation charged against it.
Transfer of Depreciation Expense to Profit and Loss Account
Depreciation expense is charged to the Profit and Loss Account or Income Statement because it is an expense relating to the use of the asset during the accounting period.
At the end of the accounting period, the depreciation expense is reflected in determining the net income or profit of the business.
The effect of depreciation is to reduce the accounting profit of the entity. However, depreciation does not involve a current cash payment and is therefore classified as a non-cash expense.
Accounting Entry under Composite Depreciation Method
Under the Composite Depreciation Method, depreciation expense is calculated by applying the composite depreciation rate to the historical cost balance of the group of assets.
The accounting entry is:
Depreciation Expense A/c Dr.
To Accumulated Depreciation A/c
For example, if the composite depreciation expense is $1,300, the entry will be:
Depreciation Expense A/c Dr. $1,300
To Accumulated Depreciation A/c $1,300
The depreciation expense is charged to the Income Statement, while accumulated depreciation is increased.
Accounting Entry on Sale of an Asset under Composite Method
When an asset is sold under the Composite Depreciation Method, cash is debited with the amount received and the asset account is credited with the original historical cost of the asset.
The difference between the original cost and cash received is adjusted against the Accumulated Depreciation Account.
The general accounting treatment is:
Cash A/c Dr.
Accumulated Depreciation A/c Dr.
To Asset A/c
Under the Composite Method, no gain or loss is recognised on the sale of an individual asset. The reason is that gains and losses arising from assets sold before or after the composite life are expected to average themselves out.
Effect of Depreciation Entries on Financial Statements
Depreciation accounting entries affect both the Income Statement and the Balance Sheet.
The debit to Depreciation Expense increases the expenses of the accounting period and therefore reduces net income reported in the Income Statement.
The credit to the Fixed Asset Account or Accumulated Depreciation Account reduces the carrying amount of fixed assets shown in the Balance Sheet.
Although depreciation reduces accounting profit, it does not directly reduce cash because no current cash outflow occurs when depreciation expense is recorded.
For this reason, depreciation is added back in the Statement of Cash Flows while reconciling net income with cash generated from operating activities.
Exam Focus
The basic accounting entry for depreciation under the direct method is:
Depreciation Expense A/c Dr.
To Fixed Asset A/c
When a separate Accumulated Depreciation Account is maintained, the entry is:
Depreciation Expense A/c Dr.
To Accumulated Depreciation A/c
Accumulated depreciation is a contra-account that reduces the carrying amount of a fixed asset while preserving its historical cost in the asset account.
Depreciation expense is charged to the Income Statement and reduces accounting profit, while accumulated depreciation affects the carrying amount of assets in the Balance Sheet.
Depreciation is a non-cash expense and does not involve a current cash outflow. Under the Composite Depreciation Method, no gain or loss is recognised on the sale of an individual asset.