Basic Accounting for Buildings and Equipment

Spreading the Cost of Major Assets over Time by Depreciation

Apr 29, 2009 James Hutchinson

When a business acquires an item that has a longer useful life such as a building or equipment, the item is expensed over a number of years using depreciation.

Accounting rules allow companies flexibility in determining whether an item is a capital item or an expense. Capital items, sometimes called Property, Plant and Equipment, are spread over multiple years, while expense items are charged all in one period.

Depreciation is the term for spreading the cost of a capital item over many years. There are many acceptable methods of depreciation, depending on the circumstances. A common method is called straight line depreciation, where the cost of the item is spread over its useful life evenly.

There is also flexibility in what constitutes a useful life, which varies by company and by item. The decision on these items has to pass a reasonability test to be accepted by an independent auditor. Governments may require using a specific life and method for tax purposes.

Capital is recorded on the books at cost, or fair market value if cost is not available, such as a donated item. To record the depreciation, a reserve account is set up to offset the capital account. This is known as an Allowance for Accumulated Depreciation.

Since Capital is an asset account, Allowance for Accumulated Depreciation is known as a contra-asset account.

An Example of Depreciation

For example, if an item is purchased for $10,000 with a useful life using straight line depreciation, the first year entries are:

Debit - Capital __________________$10,000

Credit - Cash ________________________$10,000

Debit - Depreciation Expense ________$2,000

Credit - Accumulated Depreciation _________$2,000

Second year:

Debit - Depreciation Expense ________$2,000

Credit - Accumulated Depreciation _________$2,000

Note how the expense is spread over the five years. The original value of the capital does not change, but the net value (capital minus accumulated depreciation, as known as the book value) goes down every year. The company continues to depreciate the item until there is no net value (unless there is a salvage value when the item is disposed).

• When the item has been completely expensed, known as fully depreciated, the entries are stopped. Even if the item continues to be used, it remains on the books at zero net value until it is disposed of.
• When the item is sold, trashed or otherwise disposed of, both the original capital (cost) and accumulated depreciation are removed from the books, whether it has been fully depreciated or not.
• If the item is sold for more than the book value, the company records a gain on sale of capital. If it is sold for less than book value (or zero money is received), then the difference is a loss on sale.

A basic understanding of capital will assist business owners and investors in making an informed decision. For specific situations, consult a qualified accountant.

The copyright of the article Basic Accounting for Buildings and Equipment in Accounting is owned by James Hutchinson. Permission to republish Basic Accounting for Buildings and Equipment in print or online must be granted by the author in writing.

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