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. As time passes, the value of a fixed asset diminishes. This is know as "depreciation", and is caused by two types of deterioration – physical and functional.
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.
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.
Straight-line depreciation expense is computed using this formula:
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:
= $8,000 per year
What if the delivery van has an estimated residual value of $10,000 after 5 years? The depreciation expense then would be computed as:
= $6,000 per year
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 2018, $6,000 for 2019, $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.
|Less: Acc. Dep.||6,000||12,000||18,000||24,000||30,000|
Notice that at the end of the useful life of the asset, the carrying value is equal to the residual value.
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.
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