Chapter 5
The Accounting Cycle: Adjustments
117
Depreciation
We learned that items such as land, furniture, computers and automobiles fall under the property,
plant and equipment category.These assets are used to run the business and generate sales.However,
with the exception of land, these assets will eventually become obsolete, unusable or broken. This
may not happen for several years, but however long it is, the length of time the asset can be used is
called the
useful life
.
In a sense, these long-term assets are like prepaid expenses in that the asset is purchased and then
used up over time.
Depreciation
is how accountants allocate the cost of a long-term asset over
its useful life. The reason that land does not depreciate is that land does not have a limited useful
life. Depreciation matches the expense of the long-term asset to the period in which it generates
revenue for the business.
For example, suppose a machine was purchased for $10,000 one year ago and depreciation of
$2,000 must be recorded. The $2,000 of depreciation is a reduction of the value of the machine
which gives us the net book value of the machine. The
net book value
of the asset is its original
value less the total depreciation that has been recognized.This does not represent what it could be
sold for; net book value is just the accounting value of the asset. Thus, the net book value of the
machine after recording depreciation will be $8,000. However, ASPE requires the original amount
(or historical cost) of the asset to be recorded on the balance sheet. Accounting for depreciation
requires a special account called a contra account.
Contra Account
Contra means opposite. A
contra account
is linked to another account and records decreases in
the value of that account. This is done so that the original value of the related account remains
unchanged.The value of the contra account is subtracted from the related account to arrive at a net
book value for the item. In the case of property, plant and equipment (PPE), the contra account is
called
accumulated depreciation
.This contra asset account will reflect the decrease in the net book
value of PPE without changing the original cost of the asset.
With the exception of land, every asset that is considered part of property, plant and equipment
will have its own separate accumulated depreciation account to track the decrease in net book value.
Suppose an asset was purchased for $10,000 and since it was purchased,$2,000 worth of depreciation
has been recorded. To preserve the original amount paid of $10,000, the asset account under PPE
is not directly adjusted. Instead, as illustrated in Figure 5.17, accumulated depreciation records
the total decrease in net book value of the asset. The contra asset account is called accumulated
depreciation because the depreciation accumulates as the asset’s cost is allocated to each period.
This is different from depreciation expense, an income statement account which only shows the
depreciation for the current period.
