Depreciation:
Depreciation is the acquisition cost of an asset (less the expected salvage value) spread
over the economic life of that asset. The purpose of charging depreciation over the
economic life of the asset is to match the cost of the asset over the period for which
revenue is earned by using the asset.
There are two methods of recording depreciation. Under the first method, the asset
account is directly credited for the depreciation and the written down value is readily
ascertained. The journal entry to record depreciation under the method is
Depreciation A/c Dr.
To Asset A/c
Under the second method, the depreciation charged is credited to a depreciation provision
a/c and the written down value of the asset is shown in the balance sheet by deducting the
provision from the original cost of the asset. The journal entry recorded under this method
is
Depreciation A/c Dr.
To Depreciation Provision A/c
Balance in Depreciation is transferred to Profit and Loss A/c.
The accounting entry is as under:
Profit and Loss A/c Dr.
To Depreciation A/c
Depreciation provision account, if opened, will be shown by way of deduction from the
relevant asset a/c in the balance sheet.
How to write off a fixed asset
A fixed asset is written off when if the asset is sold off or otherwise disposed of. A
write off involves removing all traces of the fixed asset from the balance sheet, so that
the related fixed asset account and accumulated depreciation account are reduced.
There are two scenarios under which a fixed asset may be written off. The first situation
arises when you are eliminating a fixed asset without receiving any payment in return.
This is a common situation when a fixed asset is being scrapped because it is obsolete
or no longer in use, and there is no resale market for it. In this case,
Adjusting Entry for Depreciation Expense
When a fixed asset is acquired by a company, it is recorded at cost (generally, cost is equal
to the purchase price of the asset). This cost is recognized as an asset and not expense.
The cost is to be allocated as expense to the periods in which the asset is used. This is
done by recording depreciation expense.
There are two types of depreciation – physical and functional depreciation.
Physical depreciation results from wear and tear due to frequent use and/or exposure to
elements like rain, sun and wind.
Functional or economic depreciation happens when an asset becomes inadequate for its
purpose or becomes obsolete. In this case, the asset decreases in value even without any
physical deterioration.
Understanding the Concept of Depreciation
There are several methods in depreciating fixed assets. The most common and simplest is
The straight-line depreciation method.
Under the straight line method, the cost of the fixed asset is distributed evenly over the life
of the asset.
For example, ABC Company acquired a delivery van for $40,000 at the beginning of 2012.
Assume that the van can be used for 5 years. The entire amount of $40,000 shall be
distributed over five years, hence a depreciation expense of $8,000 each year.
Straight-line depreciation expense is computed using this formula:
Depreciable Cost – Residual Value
Estimated Useful Life
Depreciable Cost: Historical or un-depreciated cost of the fixed asset
Residual Value or Scrap Value: Estimated value of the fixed asset at the end of its useful
life
Useful Life: Amount of time the fixed asset can be used (in months or years)
In the above example, there is no residual value. Depreciation expense is computed as:
= $40,000 – $0
5 years
= $8,000 / year
With Residual Value
What if the delivery van has an estimated residual value of $10,000? The depreciation
expense then would be computed as:
= $40,000 – $10,000
5 years
= $30,000
5 years
= $6,000 / year
Journal Entry for the Fixed Asset:
When a fixed asset is added, the applicable fixed asset account is debited and
accounts payable is credited.
How to Record Depreciation Expense
Depreciation is recorded at expense account by
This is recorded at the end of the period (usually, at the end of every month, quarter, or
year).
The entry to record the $6,000 depreciation every year would be:
Dec 31 Depreciation A/c -Van
6,000.00
Accumulated
Depreciation
6,000.00
Depreciation Expense: An expense account; hence, it is presented in the income
statement. It is measured from period to period. In the illustration above, the depreciation
expense is $6,000 for 2012, $6,000 for 2013, $6,000 for 2014, etc.
Accumulated Depreciation: A balance sheet account that represents the accumulated
balance of depreciation. Accumulated Depreciation is credited
when Depreciation Expense is debited in each accounting period.
It is continually measured; hence the accumulated depreciation balance is $6,000 at the
end of 2012, $12,000 in 2013, $18,000 in 2014, $24,000 in 2015, and $30,000 in 2016.
Accumulated depreciation is a contra-asset account. It is presented in the balance sheet as
a deduction to the related fixed asset. Here's a table illustrating the computation of the
carrying value of the delivery van.
2012
Delivery Van - Historical Cost
2014
2015
2016
$40,000 $40,000 $40,000 $40,000 $40,000
Less: Accumulated Depreciation
Delivery Van - Carrying Value
2013
6,000
12,000
18,000
24,000
30,000
$34,000 $28,000 $22,000 $16,000 $10,000
Notice that at the end of the useful life of the asset, the carrying value is equal to the
residual value.
Depreciation for Acquisitions Made Within the Period
The delivery van in the example above has been acquired at the beginning of 2012, i.e.
January. Therefore, it is easy to calculate for the annual straight-line depreciation. But what
if the delivery van was acquired on April 1, 2012?
In this case we cannot apply the entire annual depreciation in the year 2012 because the
van has been used only for 9 months (April to December). We need to prorate.
For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500.
Years 2013 to 2016 will have $6,000 annual depreciation expense.
In 2017, the van will be used for 3 months only (January to March) since it has a useful life
of 5 years (i.e. April 1, 2012 to March 31, 2017).
The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus completing
the accumulated depreciation of $30,000.
2012 (April to December)
$ 4,500
2013 (entire year)
6,000
2014 (entire year)
6,000
2015 (entire year)
6,000
2016 (entire year)
6,000
2017 (January to March)
Total for 5 years
1,500
$ 30,000
Accounting for Bad Debts
While making sales on credit, the company is well aware that not all of its debtors will pay
in full and the company has to encounter some losses called bad debts. Bad debts
expenses can be recorded using two methods viz. 1.) Direct write-off method and 2.)
Allowance method.
#1 – Direct Write-Off Method
Bad debts are recorded as a direct loss from defaulters, writing off their accounts and
transferred in full amount to P&L account, thus lowers your net profit.
E.g. Mr. Unreal passed away and will not be able to make any payment.
#2 – Allowance Method
Charge the reverse value of accounts receivables for doubtful customers to a contra
account called allowance for doubtful account. This keeps the P&L account unaffected
from bad debts and reporting of the direct loss against revenues can be avoided. However
writing-off the account at a future date is possible. For example:a) Mr. Unreal incurred losses and is not able to make payment at due dates.
b) Mr. Unreal goes bankrupted and will not pay at all.
c) Mr. Unreal has recovered from initial losses and wants to pay all of its previous debts.
Adjusting Entry for Bad Debts Expense
Companies provide services or sell goods for cash or on credit. Allowing credit tends to
encourage more sales.
However, businesses that allow credit are faced with the risk that their receivables may not
be collected.
Accounts receivable should be presented in the balance sheet at net realizable value, i.e.
the most probable amount that the company will be able to collect.
Net realizable value for accounts receivable is computed like this:
Accounts Receivable (Gross Amount)
Less: Allowance for Bad Debts
Accounts Receivable (Net Realizable Value)
$100,000
3,000
$ 97,000
Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the
estimated portion of the Accounts Receivable that the company will not be able to collect.
Take note that this amount is an estimate. There are several methods in estimating
doubtful accounts.The estimates are often based on the company's past experiences.
To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end
of the period. The adjusting entry for bad debts looks like this:
Dec 31 Bad Debts Expense
Allowance for Bad Debts
xxx.xx
xxx.xx
Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account; hence, it is
presented in the income statement. It represents the estimated uncollectible amount for
credit sales/revenues made during the period.
Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account
that represents the total estimated amount that the company will not be able to collect
from its total Accounts Receivable.
What is the difference between Bad Debts Expense and Allowance for Bad Debts?
Bad Debts Expense is an income statement account while the latter is a balance sheet
account. Bad Debts Expense represents the uncollectible amount for credit sales made
during the period. Allowance for Bad Debts, on the other hand, is the uncollectible portion
of the entire Accounts Receivable.
You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of
Bad Debts Expense and Allowance for Bad Debts. However, it is a good practice to use a
uniform pair. Some say that Bad Debts have a higher degree of uncollectibility that
Doubtful Accounts. In actual practice, however, the distinction is not really significant.
Here's an Example
Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period
will not be collected. The entry at the end of the period would be:
Dec 31 Bad Debts Expense
100.00
Allowance for Bad Debts
100.00
Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair
every time. For example:
Dec 31 Doubtful Accounts Expense
100.00
Allowance for Doubtful
Accounts
100.00
If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts
is $100, then the Accounts Receivable shall be presented in the balance sheet at $3,300 –
the net realizable value.
Accounts Receivable (Gross Amount)
Less: Allowance for Bad Debts
Accounts Receivable - Net Realizable Value
$ 3,400
100
$ 3,300
Reverse any accumulated depreciation and
Reverse the original asset cost.
If the asset is fully depreciated, that is the extent of the entry.
For example, ABC Corporation buys a machine for $100,000 and recognizes $10,000 of
depreciation per year over the following ten years. At that time, the machine is not
only fully depreciated, but also ready for the scrap heap. ABC gives away the machine
for free and records the following entry.
Debit
Accumulated depreciation
100,000
Credit
Machine asset
100,000
A variation on this first situation is to write off a fixed asset that has not yet been
completely depreciated. In this situation, write off the remaining undepreciated
amount of the asset to a loss account. To use the same example, ABC Corporation
gives away the machine after eight years, when it has not yet depreciated $20,000 of
the asset's original $100,000 cost. In this case, ABC records the following entry:
Debit
Loss on asset disposal
20,000
Accumulated depreciation
80,000
Machine asset
Credit
100,000
The second scenario arises when you sell an asset, so that you receive cash (or some
other asset) in exchange for the fixed asset you are selling. Depending upon the price
paid and the remaining amount of depreciation that has not yet been charged to
expense, this can result in either a gain or a loss on sale of the asset.
For example, ABC Corporation still disposes of its $100,000 machine, but does so after
seven years, and sells it for $35,000 in cash. In this case, it has already recorded
$70,000 of depreciation expense. The entry is:
Debit
Credit
Cash
35,000
Accumulated depreciation
70,000
Gain on asset disposal
5,000
Machine asset
100,000
What if ABC Corporation had sold the machine for $25,000 instead of $35,000? Then
there would be a loss of $5,000 on the sale. The entry would be:
Debit
Cash
25,000
Accumulated depreciation
70,000
Loss on asset disposal
Machine asset
Credit
5,000
100,000
A fixed asset write off transaction should only be recorded after written authorization
concerning the targeted asset has been secured. This approval should come from the
manager responsible for the asset, and sometimes also the chief financial officer.
Fixed asset write offs should be recorded as soon after the disposal of an asset as
possible. Otherwise, the balance sheet will be overburdened with assets and
accumulated depreciation that are no longer relevant. Also, if an asset is not written
off, it is possible that depreciation will continue to be recognized, even though there is
no asset remaining. To ensure a timely write off, include this step in the monthly
closing procedure.
Salary Expense
Reversing entries are optional accounting procedures which may sometimes prove useful
in simplifying record keeping. A reversing entry is a journal entry to “undo” an adjusting
entry. Consider the following alternative sets of entries.
The first example does not utilize reversing entries. An adjusting entry was made to record
$2,000 of accrued salaries at the end of 20X3. The next payday occurred on January 15,
20X4, when $5,000 was paid to employees. The entry on that date required a debit to
Salaries Payable (for the $2,000 accrued at the end of 20X3) and Salaries Expense (for
$3,000 earned by employees during 20X4).
The next example revisits the same facts using reversing entries. The adjusting entry in
20X3 to record $2,000 of accrued salaries is the same. However, the first journal entry of
20X4 simply reverses the adjusting entry. On the following payday, January 15, 20X5, the
entire payment of $5,000 is recorded as expense.
Illustration Without Reversing Entries
Illustration With Reversing Entries
The net impact with reversing entries still records the correct amount of salary expense for
20X4 ($2,000 credit and $5,000 debit, produces the correct $3,000 net debit to Salaries
Expense). It may seem odd to credit an expense account on January 1, because, by itself, it
makes no sense. The credit only makes sense when coupled with the subsequent debit on
January 15. Notice from the following diagram that both approaches produce the same
final results:
BY COMPARING THE ACCOUNTS AND AMOUNTS, NOTICE THAT THE SAME END RESULT
IS PRODUCED!
In practice, reversing entries will simplify the accounting process. For example, on the first
payday following the reversing entry, a “normal” journal entry can be made to record the
full amount of salaries paid as expense. This eliminates the need to give special
consideration to the impact of any prior adjusting entry.
Reversing entries would ordinarily be appropriate for those adjusting entries that involve
the recording of accrued revenues and expenses; specifically, those that involve future cash
flows. Importantly, whether reversing entries are used or not, the same result is achieved!
Wages
It might be helpful to look at the accounting for both situations to see how difficult
bookkeeping can be without recording the reversing entries. Let’s look at let’s go back to
your accounting cycle example of Paul’s Guitar Shop.
In December, Paul accrued $250 of wages payable for the half of his employee’s pay period
that was in December but wasn’t paid until January. This end of the year adjusting journal
entry looked like this:
Accounting with the reversing entry:
Paul can reverse this wages accrual entry by debiting the wages payable account and
crediting the wages expense account. This effectively cancels out the previous entry.
But wait, didn’t we zero out the wages expense account in last year’s closing entries? Yes,
we did. This reversing entry actually puts a negative balance in the expense. You’ll see why
in a second.
On January 7th, Paul pays his employee $500 for the two week pay period. Paul can then
record the payment by debiting the wages expense account for $500 and crediting the
cash account for the same amount.
Since the expense account had a negative balance of $250 in it from our reversing entry,
the $500 payment entry will bring the balance up to positive $250– in other words, the half
of the wages that were incurred in January.
See how easy that is? Once the reversing entry is made, you can simply record the
payment entry just like any other payment entry.
Accounting without the reversing entry:
If Paul does not reverse last year’s accrual, he must keep track of the adjusting journal
entry when it comes time to make his payments. Since half of the wages were expensed in
December, Paul should only expense half of them in January.
On January 7th, Paul pays his employee $500 for the two week pay period. He would debit
wages expense for $250, debit wages payable for $250, and credit cash for $500.
The net effect of both journal entries have the same overall effect. Cash is decreased by
$250. Wages payable is zeroed out and wages expense is increased by $250. Making the
reversing entry at the beginning of the period just allows the accountant to forget about
the adjusting journal entries made in the prior year and go on accounting for the current
year like normal.
As you can see from the T-Accounts above, both accounting method result in the same
balances. The left set of T-Accounts are the accounting entries made with the reversing
entry and the right T-Accounts are the entries made without the reversing entry.
Provision for Bad Debts, Cash Discounts Payable and Cash Discounts Receivable:
Bad Debts:
The sales revenue recorded in the books of accounts of an organisation represent the
amount realized or to be realized from the sale of goods. When goods are sold on credit it
may sometimes happen that even though customers bought them with every intention of
paying for them, due to certain subsequent change in circumstances, they may not be able
to fulfill their obligations.
For instance, if a customer, subsequent to the date of credit sales, is adjusted an insolvent
and his estate cannot pay anything towards satisfaction of the amount due from him, then
logically, the entry passed at the time of sale should be removed by reversing it, as the
situation is similar to the sale not having taken place. In practice, however, instead of
reversing the previous entry, the amount which cannot be recovered is considered as a loss
called ‘Bad debts’.
Example:
ABC Ltd., had debtors outstanding to the extent of Rs. 7,50,000/- as on 31st March, 2013
Mr. X, who owed Rs. 15,000/- to the company has been adjudged insolvent and his estate
is unable to pay anything.
The journal entry to record the above loss would be:
Bad debts A/c Dr. 15,000/To X A/c Cr. 15,000/Note that the sales account remains unchanged. However, in the income statement, while
sales revenue will appear at the full figure, the bad debts will appear as a loss and thus the
reduction in the amount realised will be accounted for. The Accounts Receivable account
will also appear in the Balance Sheet at the realisable value of Rs. 7, 35,000.
The journal entry for recording bad debts is:
Bad Debts A/c Dr.
To Accounts Receivable A/c
Provision for Bad and Doubtful Debts:
We have already seen that according to the realisation concept, the amount to be
recognised as revenue is the amount that is reasonably certain to be realised. When there
is a possibility that all the sales revenue may not be realised in the future due to
occurrence of bad debts, the sales revenue, then, in the income statement should reflect
this position. However, in practice, the sales revenue is shown as the gross figure and any
possible loss due to bad debts is shown as an expense.
When bad debts are expected to occur in the future:
(a) The exact amount of loss may not be known and
(b) A particular debtor’s account cannot be identified to write off the expected loss or even
if the debtor’s account can be identified, a reduction in claim can be given effect to only
when it becomes certain.
To circumvent these problems, usually, a provision is made for the expected bad debts loss
out of profits of the current year. This reduces the profit and hence the income statement
conforms to the realisation principle and also prevents an estimated portion of profits from
being distributed to the proprietors. For creating the provision for bad and doubtful debts,
the journal entry is,
Profit and Loss A/c Dr.
To Provision for Bad Debts A/c.
Example:
The Accounts Receivable of PQR Ltd. was Rs. 1, 50,000/- as on 31st March, 2012. It was
estimated that Rs. 5,000/- of the amount due may turn out to be uncollectable during the
forthcoming year.
For creation of the provision the journal entry will be,
Profit and Loss A/c Dr. 5,000/To Provision for Bad Debts A/c 5,000/While the amount of the possible loss will appear on the debit side of the profit and loss
account, the provision created, though a liability will be shown as a deduction from
Accounts Receivable on the asset side of balance sheet. This would ensure that the current
asset is shown at the realizable value.
Estimating Bad and Doubtful Debts:
Any one of the following methods may be used to estimate the amount of possible
bad debts:
1. Bad debts may be estimated as a percentage of total sales during the year. This method
can be used only when there are no cash sales or such sales are negligible.
2. Bad debts may be estimated as a percentage of credit sales.
3. Estimate bad debts as a percentage of receivable outstanding at the end of the
accounting period.
The percentage used will be based on the judgment of the management and the past
experience with regard to bad debts. Another logical way to estimate bad debts would be
to draw up an aging schedule for the outstanding debtors and apply different percentages
for amounts outstanding for various lengths of time.
Treatment of Bad Debts when a Provision for Bad Debts Exists:
Let us extend the example of PQR Ltd., to the financial year ending 31st March, 2012.
The following details are available:
Bad Debts during the year Rs. 3,500
Accounts Receivable as on 31.3.2012 Rs. 1, 70,000/PQR Ltd., would like to maintain the provision at 5% of Sundry Debtors.
The Accounts Receivable of Rs. 1,70,000/- as on 31/3/2012 is after account for the bad
debts of Rs. 3,500/-. When bad debts occurred, the following entry would have been
passed:
Bad Debts A/c Dr. 3,500/To Sundry Debtors A/c 3,500/Since provision for bad debts to the extent of Rs. 5,000/- already exists, the actual bad
debts of Rs. 3,500/- will be transferred at the end of the year to this provision account and
not to the profit and loss account.
The entry for the transfer will be:
Provision for the Bad Debts A/c Dr. Rs. 3,500
To Bad Debts A/c Rs. 3,500
At this point the provision A/c will appear as under:
Since the provision has been utilised to the extent of Rs. 3,500/-, only Rs. 1,500/- is left for
setting off any bad debts in the forthcoming year. However, PQR Ltd., wishes to maintain
the provision at 5% on debtors. So, the balance required in the provision account as on
31.03.2012 is,
1, 70,000 x 5/100 = Rs. 8,500
To bring up the provision to the required balance a further appropriation of Rs. 7,000/- (Rs.
8,500/- – Rs. 1,500/-) will have to be made from the profits and loss account. Entry will be,
Profit and Loss A/c Dr. 7,000.00
To Provision for Bad Debts A/c 7,000.00
The provision account after positing this entry will appear as follows:
The balance sheet will again show the Accounts Receivable at their realisable value.
We will extend the above example to yet another financial year.
The following details are available for the year ending 31.3.2013
Bad Debts during the year 1,000.00
Sundry Debtors as on 31.3.2013 1, 10,000
PQR Ltd., would like to maintain the provision for bad debts as 5% of debtors.
As in the previous year, the total bad debts will be transferred to the provision for bad
debts.
Provision for Bad Debts A/c Dr. 1,000.00
To Bed Debts A/c. 1,000.00
The provision account after the above transfer will appear as follows:
The provision required on the closing debtors will be,
(5 x 100) x 1, 10,000 = Rs. 5,500/The opening provision of Rs. 8,500/- has been utilised only to the extent of Rs. 1,000/- and
therefore, Rs. 7,500/- is the amount available for further appropriation. Since the balance to
be carried forward to the next accounting year is only Rs. 5,500/- a sum of Rs. 2,000/(7,500/- less 5,500/-) can be transferred back to Profit and Loss A/c as excess provision
which is not required to be carried forward. So, to retain a balance of Rs. 5,500/- in the
provision account, the journal entry will be,
Provision for Bad Debts A/c Dr. 2,000.00
To Profit & Loss A/c 2,000.00
Recovery for Bad Debts Written Off:
Sometimes, an amount written off as bad debts may be subsequently recovered. Any such
recovery must be treated as a windfall and transferred to the profit and Loss A/c as a gain.
The journal entries will be,
At the time of receipt of the amount
Bank A/c or Cash A/c Dr.
To Bad Debts Recovered A/c
At the end of the financial year,
Bed Debts Recovered A/c Dr.
To Profit and Loss A/c
Provision for Discounts on Accounts Receivable:
The organisations which allow the facility of making payments before the due date and
enable their debtors to avail of cash discounts, must take into account the possible amount
of discounts that may be allowed on closing debtors in the forthcoming year. This is
necessary to show the closing debtors at their realisable value.
The principles for creation and maintenance of the provisions for discounts on debtors are
the same as those discussed in the section on provision for bad debts. The only additional
point to be noted is that discounts will be estimated on debts considered goods i.e.,
closing sundry debtors minus provision for bad debts.
The illustration given clearly explains the methods of maintaining a provision for discounts
on debtors.
The following details are available for M Limited:
While the company maintains 5% provision for bad debts, it would like to maintain 3%
provision for discounts beginning from 31.3.2011. The entries in the provision for discounts
on receivable and the relevant extracts from the balance sheets are shown below: