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Adjusting Entry for Depreciation Expense

Introduction

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.

In a Nutshell

Depreciation expense is recorded to allocate costs to the periods in which an asset is used.

The journal entry for depreciation expense is:
  Dr Depreciation Expense
  Cr Accumulated Depreciation

This lesson will help you understand the concept of depreciation and provide examples in calculating and 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 2018. 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.

Illustration of depreciation expense

Straight-line depreciation expense is computed using this formula:

Historical Cost – Residual Value
Estimated Useful Life

Historical Cost: Purchase price and all incidental cost of the 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 per year

With Residual Value

What if the delivery van has an estimated residual value of $10,000 after 5 years? The depreciation expense then would be computed as:

= $40,000 – $10,000
5 years

= $30,000
5 years

= $6,000 per year

Illustration of depreciation expense; fixed asset has residual value

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 2018, $6,000 for 2018, $6,000 for 2020, 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 2018, $12,000 in 2019, $18,000 in 2020, $24,000 in 2021, and $30,000 in 2022.

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 for each year of its useful life.

  2018   2019   2020   2021   2022
Historical Cost $40,000   $40,000   $40,000   $40,000   $40,000
Less: Acc. Dep. 6,000   12,000   18,000   24,000   30,000
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 2018, 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, 2018?

In this case we cannot apply the entire annual depreciation in the year 2018 because the van has been used only for 9 months (April to December). We need to prorate.

For 2018, the depreciation expense would be: $6,000 x 9/12 = $4,500.

Years 2019 to 2022 will have full $6,000 annual depreciation expense.

In 2023, the van will be used for 3 months only (January to March) since it has a useful life of 5 years (i.e. from April 1, 2018 to March 31, 2023).

The depreciation expense for 2023 would be: $6,000 x 3/12 = $1,500, and thus completing the accumulated depreciation of $30,000.

2018 (April to December) $ 4,500
2019 (entire year) 6,000
2020 (entire year) 6,000
2021 (entire year) 6,000
2022 (entire year) 6,000
2023 (January to March) 1,500
Total for 5 years $ 30,000

Alternatively, you can use "months" instead of "years" for useful life. In our example the useful life is 5 years, which is 60 months. Monthly depreciation would then be $500 (i.e. $30,000 / 60 months). The total depreciation in 2018 for 9 months would still be $4,500.

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