Depreciation

Accounting 11

Depreciation Assets that a company owns, which are expected to last more than one year, are called Fixed Assets. These assets include such things as automobiles, computers, furniture, office buildings and equipment. These fixed assets that a company owns have a set amount of useful life. This means that a fixed asset is not expected to last forever, and thus its value depreciates over time. The definition of depreciation is the decline in the useful life of a fixed asset. The only fixed asset that does not decline, except in very rare circumstances, is land. Land retains its value and most often appreciates, so deprecation is not applicable in most cases. Depreciation represents an expense for a business. The business’ fixed assets are Decreased by a certain value each year and because the accounting equation must always remain in balance, this decrease must be accounted for somehow. Even though the dollar amount of depreciation is not paid for in cash, the loss in value of the fixed asset must be balanced out and this is done by using two accounts:   Depreciation Expense  Accumulated Depreciation The Depreciation Expense account is used to capture the dollar value of depreciation for an accounting period. Accumulated Depreciation is used to show a running total of how much a fixed asset has depreciated. This account is called a contra account because it relates to an asset account. In the case of accumulated deprecation, the account is called a contra-asset account and it always has a credit value. The balance in the accumulated depreciation account is the amount of the fixed asset that has already expired. Rather than simply decrease the value of the original asset account, the accumulated depreciation account is used. When a company purchases a fixed asset, the purchase amount is posted to the fixed asset account and that original purchase price is recorded on the balance sheet. When a reader looks at the financial statements, he/she wants to know both the original purchase price and the amount of depreciation that has been accounted for. The reason for this is that the amount for a fixed asset shown on the Balance Sheet is not the market price or the amount that asset is worth. It is the amount, which was originally paid less the accumulated deprecation.

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Example: Ted’s trucking has a truck that was purchased for $15,000 on January 1, 2005. As of December 31, the truck has depreciated $1500. The following shows the journal entries Involved: Original entry: Jan 1 (Debit) Truck (Credit) Cash Purchase of truck

$15,000 $15,000

Adjusting entry: Dec 31 (Debit) Depreciation Expense (Credit) Accumulated Depreciation To record depreciation for the year

$1,500 $1,500

After this transaction, the balance in the Truck account is still $15,000 and therefore the amount on the Balance Sheet is $15,000 but the net value (also known as the net book value) of the Truck is $13,500. This is shown on the Balance Sheet like this: Fixed Assets Truck $15,000 Less: Accumulated Depreciation 1,500 Net Truck $13,500 The net value of an asset is called its book value. This is the value it has on the balance sheet. This has nothing to do with how much the asset costs, how much it is worth, or how much you would earn from selling it.

Calculating Depreciation Depreciation is calculated using the following methods: straight-line and accelerated

1. Straight-line Depreciation This method assumes equal amounts of depreciation over an asset’s useful life. This translates to equal depreciation expense amounts every period.

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The formula for calculating straight-line depreciation is: Cost – Salvage Value Useful Life Cost = Useful Life = Salvage value =

Purchase price of the asset Estimated amount of time that the asset will be used by the company. This is sometimes called service life. Estimated amount the asset can be sold for at it end of its useful life. This is sometimes called residual value.

Example (continued): The truck that Ted’s Trucking purchased for $15,000 is expected to be used by the company for 8 years and then sold for $3,000. Depreciation is calculated as follows: Depreciation per year =

$15,000 – $3,000 = $1,500 8

Some companies may record depreciation only on a yearly basis. Other companies will record depreciation monthly. This is true when companies require accurate income statements on a monthly basis (and not just yearly)

Depreciation expense per month would be the yearly depreciation expense divided by the number of months in a year (12). Depreciation per month = $1,500 = $125 12

2A) Accelerated Depreciation (also known as the Declining Balance Method or Asset Pool Method) Under this method, the asset depreciates at a greater rate at the beginning of its life and the rate slows as the asset ages. Depreciation expense is greater up front. Many assets, such as vehicles, would fit this method of depreciation. The most common method of calculating depreciation using this method is multiplying the current net book value by a constant percent. If a company wishes to record monthly depreciation, the yearly amount is divided by 12. Page 3 of 10

Depreciation

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Depreciation expense = (Cost – Current Accumulated Depreciation) X fixed percentage This method requires a calculation for EVERY depreciation journal entry. This is different from the straight-line method which has the same depreciation expense amount throughout the useful life of the asset. The benefit of the percentage approach is that the company does not have to know the useful life of the asset nor its salvage value at the end of its useful life.

Example: Ted’s Trucking has a truck that was purchased for $15,000 on January 1, 2005. Ted’s Trucking uses the accelerated method of depreciation at a rate of 20% per year. At the end of the first year Depreciation Expense for the year = Depreciation Percentage ($15,000 – 0) X 20%

= $3,000

Cost Accumulated Depreciation prior to year-end

Accumulated Depreciation will be $0 + $3,000 = $3,000 at the end of the year. Previous Accumulated Depreciation

Current Year’s Depreciation Expense

At the end of the second year Depreciation Expense = ($15,000 – 3,000) X 20% = $2,400 Accumulated Depreciation will be $3,000 + $2,400 = $5,400 At the end of the third year Depreciation Expense = ($15,000 – $5,400) X 20% = $1,920 Accumulated Depreciation will be $5,400 + $1,920 = $7,329 The accumulated depreciation continues to grow, reducing the net book value of the asset (it is a contra-asset). The growing accumulated depreciation account reduces the yearly depreciation expense. This method results in assets that may take 50+ years to reduce net book value to less than a dollar. The straight-line method has a very clear stopping date for depreciation (when net book value = scrap value), the accumulated depreciation method does not.

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2B) Table (Accelerated Depreciation) Sometimes a table used in the accelerated depreciation method. With fixed depreciation expenses (which are also additions to accumulated depreciation) Example: Year One Depreciation Expense: Year Two Depreciation Expense: Year Three Depreciation Expense Etc.

$3,000 2,500 2,200

The values in the table are used by the bookkeeper for depreciation expense – no calculations required. Where does this information come from? Sometimes this information is provided by the manufacturer or by a consultant.

The reason for using accelerated depreciation is for income tax purposes to lessen net income. This makes sense because the higher the expenses in a given period the lower the net income.

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Student Worksheet – Depreciation

Directions: Fill in the Blanks. Circle the correct choice between parentheses.

1. ________________ is a system of allocating the cost of fixed assets over their useful life.

2. An account that accumulates the amount of a fixed asset that is “used up” is a ____________________ account. Accumulated Depreciation is an example of this type of account.

3. Another term for scrap value of an asset is _____________ value.

4. The two methods of depreciation are ________________ and _______________.

5. The formula for calculating straight-line depreciation is ____________ plus/minus ________________ divided by _________________________ .

6. Which fixed asset does not depreciate? _____________________

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7. To calculate the book value of an asset you subtract ____________________ from the ______________ cost.

8. With accelerated deprecation, the depreciation expense is (more/less) in the beginning periods after the asset is purchased. (circle either more or less)

9. In January 2005, The BBQ Pit bought a commercial freezer for $11,000 that is expected to last 15 years and have a scrap value of $200. Use the straight-line method for calculating depreciation. a. What is the yearly depreciation amount?

b. What is the journal entry made on December 31, 2005 to record the yearly depreciation? Date

Account

Account No.

Debit

Credit

c. What would be the net book value of the Freezer asset on December 31, 2005?

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d. What is the net book value of the Freezer asset at the end of the 15

th

year?

e. If the freezer were still in use after 15 years, what would the deprecation expense be for future years (16th, 17th, 18th, etc.)?

10. A fixed asset was purchased on January 1, 2008 for $20,000. The company uses the Accelerated Depreciation Method at a fixed percentage of 10%. a. What would the depreciation expense be in the first year?

b. What would the balance be in the accumulated depreciation account be at the end of the first year?

c. What would the depreciation expense in the second year?

d. What would the balance be in the accumulated depreciation account at the end of the second year?

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Answer Key: Depreciation 1. depreciation 2. contra 3. salvage 4. straight-line, accelerated 5. cost, minus, salvage or residual value, useful or service life 6. land 7. accumulated deprecation, original 8. more 9.

a. (11,000 – 200) / 15 = 720

b. DR Depreciation Expense $720 CR Accumulated Depreciation $720

c. $10,280 (11,000 – 720)

d. $200 (the scrap value)

e. $0

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10. a. Year One Depreciation: ($20,000 – 0) X 10% = $2,000 b. Accumulated Depreciation (end of year one) = $0 + $2,000 = $2,000 c. Year Two Depreciation: ($20,000 – $2,000) X 10% = $1,800 d. Accumulated Depreciation (end of year two) = $2,000 + $1,800 = $3,800

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