## 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 (Balance Sheet) Depreciation Expense (Income Statement) Accumulated Depreciation (Balance Sheet) Net Book (Carrying) Value (Balance Sheet) 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.

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