What is the impact of not depreciating fixed assets?
2. Impact of not depreciating fixed assets
What is the impact of not depreciating fixed assets? The most obvious impact is overstatement of assets on the balance sheet and overstatement of net income (or understatement of net loss) on the income statement. Consider the example we looked at earlier. If depreciation expense is not recorded every year, the following situation would take place:
Year |
Historical Cost |
Depreciation |
Accumulated |
Net Book |
1 |
100,000 |
0 |
0 |
100,000 |
2 |
100,000 |
0 |
0 |
100,000 |
3 |
100,000 |
0 |
0 |
100,000 |
4 |
100,000 |
0 |
0 |
100,000 |
5 |
100,000 |
0 |
0 |
100,000 |
n/a |
0 |
n/a |
n/a |
Annual depreciation expense is zero, so net income is artificially higher by $20,000 (in other words, if depreciation expense was recognized, net income would have been $20,000 lower). In addition, net book (carrying) value does not decrease over the file of the asset. This may create a misleading perception that all fixed assets are new because there is no accumulated depreciation while in reality the assets have been in use for some time.
The tables below provide a more compact view of what happens if fixed assets are not depreciated. The tables only show certain elements of balance sheet and income statement. Assume annual net income after depreciation expense is $45,000:
Depreciation Expense Recorded
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Balance Sheet |
|||||
Fixed assets |
|||||
Historical cost |
100,000 |
100,000 |
100,000 |
100,000 |
100,000 |
Accumulated depreciation |
(20,000) |
(40,000) |
(60,000) |
(80,000) |
(100,000) |
Fixed assets, net |
80,000 |
60,000 |
40,000 |
20,000 |
0 |
Income Statement |
|||||
Depreciation expense |
(20,000) |
(20,000) |
(20,000) |
(20,000) |
(20,000) |
Net income |
45,000 |
45,000 |
45,000 |
45,000 |
45,000 |
Depreciation Expense NOT Recorded
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Balance Sheet |
|||||
Fixed assets |
|||||
Historical cost |
100,000 |
100,000 |
100,000 |
100,000 |
100,000 |
Accumulated depreciation |
0 |
0 |
0 |
0 |
0 |
Fixed assets, net |
100,000 |
100,000 |
100,000 |
100,000 |
100,000 |
Income Statement |
|||||
Depreciation expense |
0 |
0 |
0 |
0 |
0 |
Net income |
65,000* |
65,000* |
65,000* |
65,000* |
65,000* |
(*) Because net income is reduced by depreciation expense, if depreciation expense is not recorded, net income is higher by $20,000.
This noted impact on balance sheet and income statement is the most obvious. Of course, there are also other implications of not recording depreciation expense. For example, management uses cost information to price their products or services. If depreciation expense is not recorded, the cost of fixed assets is not considered in setting sales prices, and established prices may not be high enough to cover the cost of fixed assets.
- Accounting for Long-term Assets
- How to account for an increase in the useful life of a fixed asset
- How to estimate the useful life of a fixed asset
- Accounting for self-constructed fixed assets
- Accounting for donated fixed assets
- Short and long-term classification of certain assets and liabilities (Part II)
- Accounting for preproduction costs related to long-term supply arrangements