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:
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:
= $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:
= $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:
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.
|Delivery Van - Historical Cost||$40,000||$40,000||$40,000||$40,000||$40,000|
|Less: Accumulated Depreciation||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|