Adjusting Financial Statements for Depreciating Assets
When you close your business’s books for an accounting period, you may need to make some adjustments to the financial statements for depreciating assets. Recording asset depreciation in this way recognizes the use of assets in your business during the accounting period.
The largest noncash expense for most businesses is depreciation. Depreciation is an accounting exercise that reflects the use and aging of assets. Older assets need more maintenance and repair and also need to be replaced eventually. As the depreciation of an asset increases and the value of the asset dwindles, the need for more maintenance or replacement becomes apparent.
The time to actually make this adjustment to the books is when you close the books for an accounting period. (Some businesses record depreciation expenses every month to more accurately match monthly expenses with monthly revenues, but most business owners only worry about depreciation adjustments on a yearly basis, when they prepare their annual financial statements.)
Depreciation doesn’t involve the use of cash. By accumulating depreciation expenses on an asset, you’re reducing the value of the asset as shown on the balance sheet.
Readers of your financial statements can get a good idea of the health of your assets by reviewing accumulated depreciation. If assets are close to being fully depreciated, the report reader knows that you’ll probably need to spend significant funds on replacing or repairing those assets sometime soon. As he evaluates the financial health of the company, he takes that future obligation into consideration before making a decision to loan money to the company or possibly invest in it.
Usually, you calculate depreciation for accounting purposes using the straight-line depreciation method. This method is used to calculate an amount to be depreciated that will be equal each year based on the anticipated useful life of the asset.
As an example, suppose your company purchases a car for business purposes that costs $25,000. You anticipate that the car will have a useful lifespan of five years and will be worth $5,000 after five years. Using the straight-line depreciation method, you subtract $5,000 from the total car cost of $25,000 to find the value of the car during its five-year useful lifespan ($20,000).
Then, you divide $20,000 by 5 to find your depreciation expense for the car ($4,000 per year). When adjusting the assets at the end of each year in the car’s five-year lifespan, your entry to the books should look like this:
|Accumulated Depreciation: Vehicles||$4,000|
|To record depreciation for Vehicles.|
This entry increases depreciation expenses, which appear on the income statement. The entry also increases Accumulated Depreciation, which is the use of the asset and appears on the balance sheet under the Vehicles asset line. The Vehicle asset line always shows the value of the asset at the time of purchase.
You can speed up depreciation if you believe that the asset will not be used evenly over its lifespan — namely, that the asset will be used more heavily in the early years of ownership.
If you use a computerized accounting system, you may or may not need to make this adjustment at the end of an accounting period. If your system is set up with an asset management feature, depreciation is automatically calculated, and you don’t have to worry about it. Check with your accountant to verify this before calculating and recording depreciation expenses.