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All about Depreciation

All about Depreciation

Depreciation expense spreads the cost of major equipment and assets over a period of time that spans a number of years. Amortization is used to allocate the cost of intangible assets, such as patents, copyrights, trademarks, and franchises. Depletion is used to record the cost of natural resources extracted from the earth.

There are three main events in the life of any asset:

  1. acquisition
  2. useful life
  3. disposal or retirement

We will make journal entries for each of these events. Over the useful life we will enter depreciation expense. At the end of the life we will record any gain or loss at the time of disposal or retirement of the asset. Sometimes assets are traded for other assets, and that must be accounted for in the same manner as a disposal or retirement.

Fixed asset acquisition
Fixed asset accounts are debited for the actual cost of fixed assets. The correct account should be debited. Some companies use a Fixed Asset Subsidiary Ledger and show a control account on the Balance Sheet, called Property, Plant and Equipment (PPE) or something similar. In these cases all fixed assets acquisitions debit PPE and the subsidiary ledger carries the details pertaining to the asset.

Depreciable cost
Buildings, equipment, vehicles, computers, furniture and fixtures are all examples of depreciable assets. We will depreciate the depreciable cost of assets. This includes the purchase price paid, sales tax, shipping and installation costs, and possibly incidental costs if they are material. Cost of fixing damage caused during shipping and installation is treated as  a Repair Expense.

Some costs are incidental to buying new equipment. A specialist might be hired to install a large printing press, or other specialized, complex piece of manufacturing equipment. This type of cost is included in the depreciable cost of the asset. 

Sometimes employees have to be trained. The cost of training may be considered part of the depreciable cost, it the amount is material to the purchase of the asset. A brief training session for one or two machine operators will probably be an immaterial amount. 

The cost of  training the entire company’s personnel when a new computer system is installed would probably be a material amount, especially in a large company. Every employee might require a day’s training or more in the new system. The loss of productivity would be a material amount, and should be classified as part of the depreciable cost of the asset.

Recording Asset Acquisitions
If a company buys land, building, equipment etc. all at the same time, the total purchase price has to be divided correctly among the various assets.

Land is a non-depreciable asset. It falls into its own category in the books and on the Balance Sheet. Don’t include land costs with other fixed asset costs, such as buildings. They must always be entered separately. Buildings will be depreciated; land will not be depreciated. 

General Journal

Date

Account

Debit

Credit

Apr-15

Land

Rs.5,000

 
 Building

Rs.45,000

 
    Cash 

Rs.10,000

    Mortgage Note Payable 

Rs.40,000

 To record purchase of land and building  
    
Apr-30Manufacturing Equipment

Rs.7,000

 
 Computers and peripherals

Rs.10,000

 
 Computer software

Rs.3,000

 
    Accounts Payable 

Rs.20,000

 To record purchase of equipment, computers and software  
 

The Useful Life of an asset is the period of time the company expects to use the asset in the business. It is also important that the asset be used as it is intended, and for the production of income. For instance, a computer that is being used as a doorstop is not contributing to the production of income, and it is also not being used as it was intended. 

[Of course, at this point some very clever student will say something like, “What if the computer is used as part of an art project displayed in the foyer of an office building? It’s not being used as intended nor in the production of income.” Well, young Einstein, objects d’art are Investments, not depreciable plant assets. Nice try, but no banana for the monkey.]

Why do assets depreciate?
For Federal Income Tax purposes, depreciation is referred to as cost recovery. The government allows you to use the cost of plant assets to offset income. You recover your cost a little bit at a time, over a number of years. Each year you reduce your income tax expense, by an amount relative to the cost recovery amount for that year. It’s a slightly strange concept if you’re not involved in preparing income taxes. But it does make sense if you think about it a bit.

For financial statement purposes, depreciation reflects a number of different influences that each affects an asset over its useful life.

  • recognize physical deterioration
  • recognize obsolescence
  • recognize a reduction in market value
  • recognize benefits derived from using the asset
  • apply a logical, systematic cost allocation over a relevant period of time
  • apply the matching principle

Each of these is important to a company. When assets are purchased, the cost is reflected in the Balance Sheet. Depreciation expense transfers that cost to the Income Statement in order to reflect the effect of the items listed above, in the financial statements. 

Usually, at this point, students are a showing a slight glaze over their eyes. I then reiterate that depreciation expense reduces income, which in turn cuts income taxes. Cutting our taxes, that’s something most of us can relate to. So depreciation is a good thing, an important thing, a joyous and wonderful thing. 

[You may now take a few moments to celebrate the joys of depreciation …ahhhhh.]

Depreciation Methods
We will study a couple of depreciation methods. There are other methods. If you study international accounting, you will find that other countries deal with these issues in a very different way than we do in the US. But we’re #1, so we must be right (hee, hee).
 

Depreciation Methodmy silly comments
Straight-Line Methodcauses problems with my spell checker because of the hyphenated word
Declining-Balance Methodoh, no. another hyphenated word. my spell checker is not happy today
MACRS (income tax method) US congress made up this word. its not in my spell checker dictionary either. whatever they were drinking that night, I want a bottle of it.

OK, let’s try this again.

Depreciation Methodmy serious comments
Straight-Line Methodan easy method that allocates an equal amount of depreciation to each time period; salvage value is used
Declining-Balance Method
(200% & 150% DB)
allocates more depreciation expense to the early years of an asset’s life, when it is new; since there should be less down-time and fewer repairs in the early years, the company should get more use out of the asset in the beginning of it’s life; no salvage value is used.
MACRS (income tax method) uses the double-declining balance method, but you only take one-half year’s depreciation in the first year, and then you switch to the straight-line method in the middle of the asset’s life, so a 5 year asset takes 6 years to depreciate. salvage value? salvage value? we don’t need no stinking salvage value!! I still want a bottle of whatever they were drinking when they dreamed this one up. 

[It is a little known fact that the US congress is responsible for the rapid growth of the computer industry during the 1980s and 1990s. The MACRS depreciation rules were so complex everyone had to buy computers just to do the calculations each year. Millions of computers were sold, just to calculate MACRS depreciation  …….. OK, I’m just kidding. You didn’t really think I was serious, did you?. Hey, this is week 8, we’re almost done.]

Selling or disposing of Fixed Assets
After selling or disposing of fixed assets, the company no longer has the asset. This requires a journal entry to remove everything in the accounting records relating to the asset. 

The depreciable cost and accumulated depreciation relating to the asset must both be removed, or reversed. There might be a gain or loss when disposing of assets. There might also be incidental costs relating to disposing of the asset. All these things should be included in the journal entry recording the disposal.

Let’s assume on September 1, the ledger shows these balances for a piece of equipment.

General Ledger
Equipment

 Date Description

 Debit

 Credit

Balance

Sep-1Balance forward

Rs.7000

 

Rs.7000

     
 

Accumulated Depreciation – Equipment

 Date Description

 Debit

 Credit

Balance

Sep-1Balance forward 

Rs.5600

(Rs.5600)

     
 

Removing these amounts from the books with a journal entry
When assets disposed of there might be a gain, loss or a wash (no gain or loss). In either case all such journal entries will start from the same place, removing the related asset cost and accumulated depreciation. This journal entry does not balance; is the beginnings of a journal entry, and must be completed when all the information is available.

General Journal

Date

Account

Debit

Credit

Sep-15

Accumulated Depreciation

Rs.5,600

 
    
    
    Equipment 

Rs.7,000

 To record disposal of equipment  
 

Notice the exact opposite of the account balances is entered for each account. This causes the account balances to go to zero after this journal entry is posted.

General Ledger
Equipment

 Date Description

 Debit

 Credit

Balance

Sep-1Balance forward

Rs.7000

 

Rs.7000

Sep-15Disposal of asset 

Rs.7000

Rs.0 

 

Accumulated Depreciation – Equipment

 Date Description

 Debit

 Credit

Balance

Sep-1Balance forward 

Rs.5600

(Rs.5600)

Sep-15Disposal of asset

Rs.5600

 

Rs.0 

 

The asset and related accumulated depreciation have both been removed from the books.
 

Calculating Book Value
Book Value is the difference between the asset cost and accumulated depreciation:
 

Equipment cost

Rs.  7,000

Less: accumulated depreciation

-5,600

Book Value before sale

Rs.  1,400

Gains and losses are calculated using the Book Value.
 

Equipment sold for a Gain

If the equipment is sold for more than its book value there will be a gain. Gains are similar to revenues, and will be recorded with a credit entry. Let’s say the equipment is sold on September 15 for Rs.2,000. The gain will be:
 

Selling Price

Rs.  2,000

Less: Book Value

– 1,400

Gain

Rs.    600

We’ll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date

Account

Debit

Credit

Sep-15

Accumulated Depreciation

Rs.5,600

 
 Cash

Rs.2,000

 
    Gain on disposal of equipment 

Rs. 600

    Equipment 

Rs.7,000

 To record disposal of equipment  
 

The journal entry is now in balance. Did you notice what I did? I started the journal entry with what I already knew – the cost and accumulated depreciation. I left 2 lines blank in the middle of the journal entry, so the sales price and gain or loss could be recorded. 
 

Equipment sold for a Loss
If the equipment is sold for less than its book value there will be a loss. Losses are similar to expenses, and will be recorded with a debit entry. Let’s say the equipment is sold on September 15 for Rs.1,000. The loss will be:
 

Selling Price

Rs.  1,000 

Less: Book Value

– 1,400 

Loss

(Rs.   400)

We’ll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

General Journal

Date

Account

Debit

Credit

Sep-15

Accumulated Depreciation

Rs.5,600

 
 Cash

Rs.1,000

 
 Loss on disposal of equipment

 Rs.  400

 
    Equipment 

Rs.7,000

 To record disposal of equipment  
 

 

Equipment sold for a Wash
If the equipment is sold equal to its book value there will be a wash. Let’s say the equipment is sold on September 15 for Rs.1,400. 
 

Selling Price

Rs.  1,400 

Less: Book Value

– 1,400 

Wash

Rs.        0 

We’ll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. In this case there is a wash, so no gain or loss is recorded. The equipment is simply removed from the books.

General Journal

Date

Account

Debit

Credit

Sep-15

Accumulated Depreciation

Rs.5,600

 
 Cash

Rs.1,400

 
    Equipment 

Rs.7,000

 To record disposal of equipment  
 

Equipment Junked
If the equipment is junked there will be a loss equal to its book value. We call this abandonment. The item is usually just thrown in the trash, or hauled to the dump. Sometimes a company will have to pay to have the item hauled away. Incidental costs are revenue expenditures, and are not included in calculating the capital gain or loss.
 

Selling Price

Rs.        0 

Less: Book Value

– 1,400 

Loss

(Rs. 1,400)

We’ll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. 

General Journal

Date

Account

Debit

Credit

Sep-15

Accumulated Depreciation

Rs.5,600

 
 Loss on abandonment of equipment

Rs.1,400

 
    Equipment 

Rs.7,000

 To record abandonment of equipment  
 

Intangible Assets
Intangibles are assets that have no physical existence. They are legal assets or accounting assets, such as copyrights, patents, trademarks or goodwill. We use a simple form of amortization, usually straight-line, to allocate the cost of these items to expenses.

All about Depreciation

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