I recently responded to a post on a property management discussion forum, and thought it would be good to post the details of that discussion here.
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The question was:
I had a new furnace installed for $1,500 after insurance sent me a check to replace it for $1,421, due to a flood. Do I depreciate the furnace and how do i deal with the insurance payment?
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Response:

Here’s how I would account for the furnace. As always, you should run this by an accountant before taking any advice… I have to absolve myself from any responsibility. (*I created a diagram showing all the transactions; it’s at the bottom of this blog post.)

First off, furnaces are typically depreciated over 15 years.

This is how I would deal with the old furnace, new furnace, and insurance payment:

Here are the accounts we will be using:

• Bank Account (asset)
• Old Furnace (asset)
• New Furnace (asset)
• Furnace Disposal Acct (asset)
  • The disposal account is used to calculate the profit/loss on the old furnace after the insurance claim. In the end, this account balance has to be -0-.
• Gain/Loss from Insurance Claim (Income or Expense)
• New Furnace Depreciation (Expense)

1) It is important to remember that the insurance check you got is not profit unless your old furnace was fully depreciated. Assuming your old furnace was not fully depreciated, the old furnace still has value. That old furnace is long gone now, so we need to zero out that book value using a “Disposal Account”. So let’s say the remaining value of the furnace is $500:

a. Credit “Old Furnace” by 500 (-)
b. Debit “Furnace Disposal Acct” by 500 (+)

2) You got the check for $1,421. You received this due to the loss of the old furnace, so this amount relates to the old furnace and will use the disposal account; then we’ll be able to see what the profit/loss on the old furnace was. We also use the bank account because that’s where the money was deposited when you received the check:

a. Credit “Furnace Disposal Acct” by 1,421 (-)
b. Debit “Bank” by 1,421 (+)

3) We can now see that the furnace disposal account has a balance of -921, which is our profit/loss (profit in this case). So, we need to zero out the account:

a. Credit “Gain/Loss from Insurance Claim” by 921 (+)
b. Debit “Furnace Disposal Acct” by 921 (+)

4) Let’s say you scrapped the old furnace and got $25 for it. We need to account for that money:

a. Credit “Furnace Disposal Account” by 25 (-)
b. Debit “Bank” by 25 (+)

–Now, we need to zero out the furnace disposal account again.–

c. Credit “Gain/Loss from Insurance Claim” by 25 (+)
d. Debit “Furnace Disposal Acct” by 25 (+)

5) The new furnace is independent from the insurance claim, so we will treat it like any other capital purchase (asset):

a. Credit “Bank” by 1,500 (-)
b. Debit “New Furnace” by 1,500 (+)

Yr 1,2,3…) The furnace is depreciated over 15 years , so depreciate 125/yr:

a) Credit “New Furnace” by 125 (-)
b) Debit “New Furnace Depreciation” by 125 (+)

Transaction Diagram: