Accounting Made Simple

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

When a company buys an asset that will probably last for greater than one year, the cost of that asset is not counted as an immediate expense. Rather, the cost is spread out over several years in a process known as depreciation.

Straight-Line Depreciation

The most basic form of depreciation is known as straight-line depreciation. Using this method, the cost of the asset is spread out equally over the expected life of the asset.

EXAMPLE: Daniel spends $5,000 on a new piece of equipment for his carpentry business. He expects the equipment to last for 5 years, by which point it will likely be of no substantial value. Each year, $1,000 of the equipment’s cost will be counted as an expense.

When Daniel first purchases the equipment, he would make the following journal entry:
                   

Then, each year, Daniel would make the following entry to record Depreciation Expense for the equipment:

       
Accumulated Depreciation is what’s known as a “contra account,” or more specifically, a “contra-asset account.” Contra accounts are used to offset other accounts. In this case, Accumulated Depreciation is used to offset Equipment.

At any given point, the net of the debit balance in Equipment, and the credit balance in Accumulated Depreciation gives us the net Equipment balance—sometimes referred to as “net book value.” In the example above, after the first year of depreciation expense, we would say that Equipment has a net book value of 4,000. (5,000 original cost, minus 1,000 Accumulated Depreciation.)

We make the credit entries to Accumulated Depreciation rather than directly to Equipment so that we:

1. Have a record of how much the asset originally cost, and
2. Have a record of how much depreciation has been charged against the asset already.

EXAMPLE (CONTINUED): Eventually, after 5 years, Accumulated Depreciation will have a credit balance of 5,000 (the original cost of the asset). At this point—once the asset has zero net book value—Daniel will make the following entry to “write off” the asset:

              
After making this entry, there will no longer be any balance in Equipment or Accumulated Depreciation.

Salvage Value

What if a business plans to use an asset for a few years, and then sell it before it becomes entirely worthless? In these cases, we use what is called “salvage value.” Salvage value (sometimes referred to as residual value) is the value that the asset is expected to have after the planned number of years of use.

EXAMPLE: Lydia spends $11,000 on office furniture, which she plans to use for the next ten years, after which she believes it will have a value of approximately $2,000. The furniture’s original cost, minus its expected salvage value is known as its depreciable cost—in this case, $9,000.

Each year, Lydia will record $900 of depreciation as follows:

         

After ten years, Accumulated Depreciation will have a $9,000 credit balance. If, at that point, Lydia does in fact sell the furniture for $2,000, she’ll need to record the inflow of cash, and write off the Office Furniture and Accumulated Depreciation balances:

Gain or Loss on Sale

Of course, it’s pretty unlikely that somebody can predict exactly what an asset’s salvage value will be several years from the date she bought the asset. When an asset is sold, if the amount of cash received is greater than the asset’s net book value, a gain must be recorded on the sale. (Gains work like revenue in that they have credit balances, and increase owners’ equity.)

If, however, the asset is sold for less than its net book value, a loss must be recorded. (Losses work like expenses: They have debit balances, and they decrease owners’ equity.)

Determining whether to make a gain entry or a loss entry is never too difficult: Just figure out whether an additional debit or credit is needed to make the journal entry balance.

EXAMPLE (CONTINUED): If, after ten years, Lydia had sold the furniture for $3,000 rather than $2,000, she would record the transaction as follows:

EXAMPLE (CONTINUED): If, however, Lydia had sold the furniture for only $500, she would make the following entry:

Other Depreciation Methods

In addition to straight-line, there are a handful of other (more complicated) methods of depreciation that are also GAAP-approved. For example, the double declining balance method consists of multiplying the remaining net book value by a given percentage every year. The percentage used is equal to double the percentage that would be used in the first year of straight-line depreciation.

EXAMPLE: Randy purchases $10,000 of equipment, which he plans to depreciate over five years. Using straight-line, Randy would be depreciating 20% of the value (100% ÷ five years) in the first year. Therefore, the double declining balance method will use 40% depreciation every year (2 x 20%). The depreciation for each of the first four years would be as follows:

EXAMPLE (CONTINUED): Because the equipment is being depreciated over five years, Randy would record $1,296 (that is, 2,160 – 864) of depreciation expense in the fifth year in order to reduce the asset’s net book value to zero.

Another GAAP-accepted method of depreciation is the units of production method. Under the units of production method, the rate at which an asset is depreciated is not a function of time, but rather a function of how much the asset is used.

EXAMPLE: Bruce runs a business making leather jackets. He spends $50,000 on a piece of equipment that is expected to last through the production of 5,000 jackets. Using the units of production method of depreciation, Bruce would depreciate the equipment each period based upon how many jackets were produced (at a rate of $10 depreciation per jacket).

If, in a given month, Bruce’s business used the equipment to produce 150 jackets, the following entry would be used to record depreciation:

Immaterial Asset Purchases

The concept of materiality plays a big role in how some assets are accounted for. For example, consider the case of a $15 wastebasket. Given the fact that a wastebasket is almost certain to last for greater than one year, it should, theoretically, be depreciated over its expected useful life.

However—in terms of the impact on the company’s financial statements—the difference between depreciating the wastebasket and expensing the entire cost right away is clearly negligible. The benefit of the additional accounting accuracy is far outweighed by the hassle involved in making insignificant depreciation journal entries year after year. As a result, assets of this nature are generally expensed immediately upon purchase rather than depreciated over multiple years. Such a purchase would ordinarily be recorded as follows:

Simple Summary

• Straight-line depreciation is the simplest depreciation method. Using straight-line, an asset’s cost is depreciated over its expected useful life, with an equal amount of depreciation being recorded each month.
• Accumulated depreciation—a contra-asset account—is used to keep track of how much depreciation has been recorded against an asset so far.
• An asset’s net book value is equal to its original cost, less the amount of accumulated depreciation that has been recorded against the asset.
• If an asset is sold for more than its net book value, a gain must be recorded. If it’s sold for less than net book value, a loss is recorded.
• Immaterial asset purchases tend to be expensed immediately rather than being depreciated.