What is depreciation? Accounting entries of depreciation
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Definition: Generally Speaking depreciation is the gradual decrease in the value of an asset due to any cause.It has been defined as “The permanent and continuing diminution in the quality,quantity or value of an asset“.
But the term depreciation is commonly used in relation to fixed assets only.It is “that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally put out of use by him”.It is a business expense and should be debited to profit and Loss account.
In accounting depreciation is an expense, but it s not a cash or bank transaction. Depreciation is the cost of an asset used during the operation of a business like manufacturing, trading etc. For example A Machinery bought by a manufacturer for 100000 uses it continually for the production during all financial period and after a few years the machinery becomes obsolete. In such a situation business needs a new machinery. It means every year business loose some value as wear and tear of a machinery. This has to accounted every year as an expense, Let’s say the term Depreciation to describe gradual conversion of the cost of a asset into expense.
Accounting of Depreciation
When an asset is purchased the major accounting problem is –
How should the costs of asset be allocated against revenue?
When an asset is purchased ,its cost is first recorded as an asset. This cost becomes expense over a period of years through the accounting process of depreciation.Buying expense of asset will not count for the calculation of revenue. At the end of each financial year a certain percentage of its value say 10% put into the expense for the calculation of profit and loss since the value of the machinery definitely reduced due to it’s continuous usage in the production process.
The depreciation decrease the value of an asset and at the same time reduces the profit. Let’s understand this with an example.
Company A Purchased a machinery of Rs 100000 for cash on April 1st 2018. At the end of March 2019 company decided to charge a 20% depreciation
Accounting Entry for depreciation
- When Purchasing an Asset, it is recorded as
Machinery a/c ………….. Dr 100000.00
To Cash a/c 100000.00
( Machinery Purchased)
- When Depreciation is charged at the end of the Financial Year.
Depreciation a/c ……………Dr 20000.00
To Machinery a/c 20000.00
( Charged 20% depreciation on total asset value )
The Ledger account shows as following.
- Asset account
- Depreciation Account
The amount in the depreciation account is transferred to profit & loss account for the calculation of profit/loss and the amount in the asset account is brought forward to the next financial year through Balance Sheet.