What is the impact of not depreciating fixed assets?

February 21, 2013

Most companies purchase and use fixed assets (also called property, plant and equipment). Fixed asset costs are allocated to multiple accounting periods by recording depreciation expense. What is the impact of not depreciating fixed assets?

1. Nature of fixed assets and their depreciation

Letís start our discussion with a definition of fixed assets.

Fixed assets (also called property, plant and equipment) are tangible assets that are used in operations of an entity and are not intended for sale. Such assets are expected to provide services to an entity for a number of years and therefore are considered long-term.

Examples of fixed assets include computers, office furniture, delivery trucks, buildings, manufacturing equipment, and so on. When a company purchases such assets, the company normally intends to use them beyond one year, and thus, the cost of such assets should be allocated to multiple accounting periods by recording depreciation.

Depreciation is the allocation of the cost of property, plant, and equipment to expenses over their useful (economic) life in a systematic and rational manner. Depreciation results in depreciation expense.

For instance, a company buys a delivery vehicle for $100,000. The company estimates that the vehicle will be in use for five years at which point it will be disposed with no salvage value. Assuming the company will use the vehicle similarly (meaning, to the same extent) every year, the straight-line depreciation method can be applied. Under the straight-line depreciation method, a proportionate share of the asset cost is expensed each year:

Depreciation Expense = $100,000 ų 5 years = $20,000 per year

So, each year the vehicle will be in use, the company will record $20,000 as depreciation expense.

Depreciation expense recorded in the income statement is also recorded in a contra-asset account called Accumulated Depreciation. Such account is subtracted from the fixed asset cost to arrive at the net book (carrying) value. Each year the vehicle is in use (and depreciation expense is recognized), the accumulated depreciation will increase by $20,000 and the net book value of the vehicle will decrease by $20,000:

Year

Historical Cost
(Balance Sheet)

Depreciation
Expense
(Income Statement)

Accumulated
Depreciation
(Balance Sheet)

Net Book
(Carrying) Value
(Balance Sheet)

1

100,000

20,000

20,000

80,000

2

100,000

20,000

40,000

60,000

3

100,000

20,000

60,000

40,000

4

100,000

20,000

80,000

20,000

5

100,000

20,000

100,000

0

 

n/a

100,000

n/a

n/a

Note that over the five-year period, $100,000 of depreciation expense will be recognized. Each year depreciation expense is recorded, net income is decreased by $20,000 (because depreciation expense reduces net income).

For a more detailed discussion of fixed assets and depreciation, refer to tutorial Accounting for Long-term Assets.

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