Depreciation of Fixed Assets – Accounting for Depreciation
In Part 1 of the article, we explored the concept of depreciation. In this article, we will look at how accountants prepare depreciation entries. As we have concluded from the previous part, depreciation involves a fall in asset value as well as an expense. There are two methods for accounting for depreciation: the “old method” and the “new method”.
The 2 Methods of Handling Depreciation
|“Old Method”||“New Method”|
|Dr. Depreciation ExpenseCr. Machinery (or other fixed assets)||Dr. Depreciation ExpenseCr. Accumulated Depreciation – Machinery (or other fixed assets)|
|Note: this method is rarely in use anymore, at least for the past two decades or so|
The “Old Method” of Depreciation
While the “old method” is considered obsolete, it won’t hurt for us to take a look at it. We debit “depreciation expense” because there is an increase in expense; we credit “machinery” (or other fixed assets) because there is a fall in asset value. If you look at it from the receive/take-out perspective, depreciation means the company “takes out” productivity from an asset; this productivity is received/ consumed by the business operation.
Say a business acquired a machine for $1,000 on 1 January 2010. This piece of machinery has an estimated useful life of 5 years. This means each year we are consuming (approximately) one-fifth of the benefits generated by the machine. This is how depreciation works under the old method:
The “New Method” and the Accumulated Depreciation Account
When learning about depreciation for the first time, many may be confused about the “new method” of depreciation. What is exactly is the “accumulated depreciation” account?
Actually the “old method” and “new method” mean the same thing; it is just that we are presenting depreciation in a different way.
The “old method” and “new method” are like the two pictures above: it is the same dish but presented differently.
Have you ever ordered fries at a restaurant and wished that the ketchup can be served separately, like the one on the right? This is similar to what users of financial statements want – the depreciation amount shown separately from the asset account.
Think about it. When you purchase a machine for $1,000, that amount is clearly shown on the receipt and hence hardly disputable. However, when you calculate depreciation like what you did above, you have made several key assumptions: that the useful life of the machine is 5 years and that the value of the machine declines at the same $200 every year.
Under the “old method”, the black-and-white figure is merged with the estimated figure. It can make things confusing for the users of financial statements. With the “new method”, the “accumulated depreciation” account is like an extension of the fixed asset account. By keeping track of the asset and its depreciation separately, we can present the figures on the Balance Sheet on separate lines.
This is how we present the fixed asset on the Balance Sheet: