Adjusting Entry for Depreciation Expense
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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 depreciationhappens 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 straightline 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
How to Record Depreciation Expense
Depreciation is recorded by debiting Depreciation Expense and crediting Accumulated Depreciation. 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 Expense
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. 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
Less: Accumulated Depreciation
2013
2014
2015
2016
$40,000 $40,000 $40,000 $40,000 $40,000
6,000
12,000
18,000
24,000
30,000
Delivery Van - Carrying Value
$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)
1,500
Total for 5 years
$ 30,000