Nature of Depreciation
The nature of depreciation was explained in Chapter 3. However, a considerable
amount of material has been covered since that explanation. You will probably want
to explain the nature of depreciation again to ensure that the class is focused on the
correct concept before beginning depreciation calculations. In this review, emphasize
once again that accounting is concerned only with allocating the cost of an asset to the
periods it is used. Accountants do not attempt to track the market value of an asset.
Use the following story
REVIEW—DEPRECIATION
Assume that you have just accepted a job that requires you to do a lot of driving. Because your
current car is on its "last leg," you have decided to purchase another car. You estimate that you
will drive 20,000 miles each year. Since you don't like to deal with major car repairs, you will
trade in the car when it reaches 60,000 miles.
You have found two cars that you are considering. One is a new car, and you can purchase it for
$18,000. The other is a late-model used car. The used car has 20,000 miles on it, but it is in
excellent condition. The price of this used car is $11,000.
Using the criteria outlined, what would be your depreciation cost per year for each car?
to reinforce the concept of depreciation, which was introduced in Chapter 3.
Assume you have just accepted a job that requires you to do a lot of driving.
Because your current car is on its "last leg," you have decided to purchase an
automobile. You estimate that you will drive 20,000 miles each year. Since
you don't like to deal with major car repairs, you will trade in the car when it
reaches 60,000 miles.
You have found two cars that you are considering. One is a new car, and you
can purchase it for $18,000. The other is a late-model used car. The used car
has 20,000 miles on it, but it is in excellent condition. The price of this used
car is $11,000.
Using the criteria outlined, what would be your depreciation cost per year for
each car?
Answer:
New Car: $18,000/3 = $6,000
Used Car: $11,000/2 = $5,500
Point out that when evaluating major purchases, we sometimes compare the cost of an
item to the number of years it will be used. In the previous example, we computed a
cost per year to compare the two automobiles.
Accounting also recognizes that whenever a long-term asset is purchased, an implicit
cost per
year is associated with that asset. A $50,000 machine that will last 5 years costs a
company $10,000 per year. And this $10,000 cost must be recognized as an expense
on each year's income statement. The process of recording this expense is known as
depreciation.
Depreciation is required because physical deterioration and/or obsolescence cause all
fixed assets, with the exception of land, to lose their usefulness. Therefore, we must
show that a portion of these assets is "used up" each year. This is similar to showing
that a portion of a company's supplies may be used up by the end of an accounting
period. These concepts can be illustrated as follows:
Supplies
Recorded as an asset
when purchased.
Supplies
Transferred to an
expense account as used.
Supplies Expense
Fixed assets
Example: Machinery
Recorded as an asset
when purchased.
Machinery
Transferred to an
expense account as used.
Depreciation Expense
REMINDER: The adjusting entry to reduce supplies credits the supplies account,
reducing it directly for the amount of supplies that are physically gone. Since
depreciation is only an estimate of the usefulness of a long-term asset that has
expired, the asset account is not reduced directly. Rather, a contra-account called
Accumulated Depreciation is used to reduce the asset.
For example, the adjusting entry to record depreciation on a piece of machinery would
be:
Depreciation Expense—Machinery……………
Accumulated Depreciation—Machinery
XXX
XXX
As a final note, stress that depreciation does not provide cash for replacing assets as
they wear out. Depreciation only allocates a past cost to current and future periods.
A business must separately budget for the replacement of assets.