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 or 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.
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
DR Truck $15,000
CR Cash $15,000
Adjusting entry Dec 31
DR Depreciation Expense $1500
CR Accumulated Depreciation $1500
To record depreciation for the year
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 of the Truck is $13,500. This is shown on the Balance Sheet like this:
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.
Depreciation is calculated in two main ways:
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.
The formula for calculating straight-line depreciation is:
Cost – Salvage Value
Cost = purchase price
Useful Life = estimated amount of time that the asset will be used by the company. This is sometimes called service life.
Salvage value = estimated amount the asset can be sold for at it end of its useful life. This is sometimes called residual value.
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 =
15000 – 3000 = $1500
Accelerated depreciation: 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.
There are many ways to calculate accelerated deprecation but one common method is to develop a table of declining depreciation values. The total depreciation remains the same but the yearly deprecation expense is gradually lessened as follows:
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.
For a teaching lesson plan for this lesson see:
Depreciation Lesson Plan and Worksheet