Every business has fixed assets—computers, office furniture, machinery, or company cars—that serve the business over an extended period.
In accounting, the matching principle says we should record expenses in the same period as the revenue they help generate. If we were to deduct the full cost of these assets immediately, it would violate this principle by showing a large expense in the first year and none thereafter, even though the asset continues to be used. This makes the company’s finances look uneven. Depreciation solves this by spreading the cost of the asset over its useful life.
As a CFO or finance leader, you are responsible for ensuring that asset values are correctly reflected in your company’s books. In this blog, we’ll walk you through the fundamentals of depreciation accounting entry.
Let’s begin by diving into what depreciation means and why it matters for your business.
Depreciation is when an asset loses value over time due to wear and tear or use. Instead of recording the full cost of an asset upfront, you spread the cost over its useful life. This prevents a big financial hit in a single year and instead records a portion of the cost each year as depreciation expense.
Example:
If you buy machinery for SAR 20,000 and plan to use it for 10 years, you would record SAR 2,000 annually as a depreciation expense.
Why it Matters:
In Saudi Arabia, proper depreciation accounting also helps businesses meet Zakat, Tax, and Customs Authority (ZATCA) requirements, particularly under VAT and tax filing rules. Incorrect depreciation can lead to fines or issues in financial reporting. The process starts with creating a depreciation accounting entry.
A depreciation journal entry records the decrease in an asset's value over time. According to the matching principle in accounting, expenses should match the revenue they help generate.
In the journal entry, you debit the depreciation expense account and credit the accumulated depreciation account. This ensures the asset’s cost is correctly reflected in your financial statements.
Suppose your company purchases office furniture for SAR 50,000 with an expected useful life of 5 years. Instead of recording the entire cost immediately, you allocate SAR 10,000 annually (SAR 50,000 ÷ 5 years) as depreciation. The journal entry for the first year would be:
Debit: Depreciation Expense SAR 10,000
Credit: Accumulated Depreciation SAR 10,000
To better understand depreciation, let’s distinguish between accumulated depreciation and depreciation expense.
Both play distinct yet interconnected roles in financial reporting. Here’s how they differ:
With a clear understanding of these concepts, let’s now explore the benefits of depreciation accounting.
Here are the key benefits of depreciation accounting entry:
Errors in depreciation accounting lead to misstated financials, higher tax liabilities, and missed investment opportunities. HAL ERP simplifies the process for you, ensuring accuracy and compliance at every step.
Let’s look at the different methods of calculating depreciation and how they impact your journal entries.
There are several methods for calculating depreciation, each impacting how depreciation is recorded in your journal entries. Let’s look at the most common methods:
The straight-line method is the simplest and most commonly used. It spreads the depreciation evenly over the asset’s useful life. Each year, the same amount of depreciation is recorded until the asset is fully depreciated.
Formula:
Depreciation Expense per Year = (Cost of Asset -Salvage Value)Useful Life
For example, if machinery costs SAR 20,000 and is expected to last for 10 years, you would record SAR 2,000 in depreciation each year (SAR 20,000 ÷ 10 years). The journal entry for this would look like:
Journal Entry:
This method records more depreciation in the earlier years of an asset’s life and less in the later years. The asset loses value faster when it’s new.
Formula:
Depreciation Expense = 2 × (Book Value at Beginning of Year × Depreciation Rate)
For example, if machinery costs SAR 20,000 and the first-year depreciation is calculated at 20%, the journal entry for the first year would be:
Journal Entry:
This method is based on how much the asset is used. It’s ideal for machines or equipment where usage varies each year.
Formula:
Depreciation Expense per Unit = (Cost of Asset -Salvage Value)Total Units Expected to be Produced
For instance, if a machine produces 10,000 units in its first year and 5,000 units in its second year, the depreciation recorded will vary based on the actual usage. The formula used for this method is:
Each method affects how much depreciation you record and how it appears in your financial statements. The choice of method depends on the type of asset and how it’s used.
Need more insights into journal entries or accounting? Explore our comprehensive knowledge center here.
Now that we’ve explored journal entries and their importance, let’s dive into the steps involved in calculating depreciation.
When you purchase an asset, its original cost is recorded in the asset account on the balance sheet. At the end of each accounting period, a depreciation journal entry is made as part of the routine adjustments.
To calculate depreciation, you need four key details:
Once you have these details, you can calculate the depreciation expense for the asset. The formula for Depreciation:
Depreciable Amount = Cost - Residual Value
(Salvage value is often assumed to be zero for simplicity.)
Using these details, you can calculate depreciation for any asset and accurately record it in your accounts. Let’s see how it works.
Once you have calculated depreciation, you’ll need to record it in your accounting system. Here’s the step-by-step process:
Before recording depreciation, ensure you have the following details:
The method you choose to calculate depreciation depends on the type of asset and how it is used. As mentioned before, here are the common methods:
Using the chosen method, calculate the annual depreciation expense. For example, using the straight-line method:
Formula: Depreciation Expense = (Cost of Asset -Salvage Value)Useful Life
Record the depreciation in your accounting system by using two accounts:
Example Entry:
Check out this video to see how journal entries are implemented with HAL Accounting Software.
Post the journal entry in your accounting software or manual ledger at the end of each period:
After recording, subtract the accumulated depreciation from the asset’s original cost to determine its book value.
To better understand the process, let’s look at an example of a depreciation journal entry.
Suppose your business purchases office furniture for SAR 45,000 on January 1. The furniture has a useful life of 5 years and a SAR 7,000 salvage value. You’ve chosen the straight-line depreciation method, which spreads the cost evenly over the asset's useful life.
First, calculate the annual depreciation expense using the straight-line formula:
Depreciation Expense = (Cost of Asset -Salvage Value)Useful Life
= (45,000 − 7,000)5 years = SAR 7,600 per year
Now that you have the annual depreciation, here’s how you record the journal entry at the end of the year:
Depreciation has a significant impact on various financial statements. Let’s explore how it affects each one:
Understanding these impacts helps you make informed decisions about asset management, tax planning, and financial forecasting.
Now, let’s explore common mistakes to avoid when handling depreciation.
Even small mistakes in depreciation can lead to significant errors in financial reporting. Here are some common challenges and how to avoid them:
i) Recording Depreciation in the Wrong Period
Solution: Record depreciation at the end of each accounting period. Set reminders or keep a schedule.
ii) Using the Wrong Depreciation Method
Solution: Choose the right method for each asset. Consult your accountant if unsure.
iii) Incorrectly Estimating Useful Life or Salvage Value
Solution: Carefully estimate the asset's useful life and salvage value. Update them if needed.
iv) Not Updating Depreciation Schedules
Solution: Keep schedules updated for new or disposed assets.
v) Forgetting to Adjust for Accumulated Depreciation
Solution: When selling or disposing of an asset, adjust the accumulated depreciation by debiting it and crediting the asset account.
vi) Misclassifying Accounts
Solution: Double-check that depreciation is correctly recorded.
vii) Switching Depreciation Methods Without Documentation
Solution: Always document and stick to one method.
Avoiding these mistakes will help keep your financial records accurate. To make depreciation accounting entry even easier, consider using tools that automate and streamline the process, like HAL ERP.
From calculating expenses to automating journal entries, HAL ERP makes accounting easier for Saudi SMEs and enterprises. It offers a comprehensive solution for managing your financial data!
Here’s how it supports CFOs and business owners:
Depreciation accounting is crucial for keeping your financial records accurate and compliant. It helps you understand the true value of your assets, manage expenses, and plan for the future. By following the right steps and methods for creating a depreciation accounting entry, you can avoid errors and improve your financial reporting.
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