Depreciation expense is a non-cash accounting practice that is used to spread the cost of an asset over its useful life.
A firm can use one of the many depreciation calculation methods available. However, each method calculates the depreciation charge differently. The accounting treatment for the depreciation cost remains the same.
Let us discuss the depreciation definition, calculation methods, and journal entries for the account books.
Depreciation – Definition
Depreciation refers to a decrease in the value of an asset due to usage, wear and tear, or obsolescence over time.
A depreciable asset can lose value due to usage, a fall in its price, or obsolescence of technology. Depreciation is the method to account for that decrease in the value of an asset over time.
Another way of defining depreciation is to charge an expense gradually over the useful life of an asset. The expense can be recorded in a series of entries that cover the full cost minus the salvage value of the asset over its expected useful life.
Depreciation expense over the years applies the matching principle of accounting. It is charged to match the cost and revenue associated with a fixed asset. In practice, it is difficult to associate the true amount of revenue generated by each fixed asset though.
Depreciation Calculation Methods
An accounting system can calculate depreciation costs in one of the several recognized methods. However, the entity must follow the same depreciation calculation method for the full accounting period.
This method spreads the depreciation cost evenly over the useful life of an asset. It considers the total years as the useful period and divides the value of the asset minus any salvage value equally.
For example, an asset worth $ 50,000 with an estimated useful life of 10 years and zero salvage value will have a depreciation cost of $ 5,000 every year.
Declining Depreciation Method
The declining method uses a similar approach to the straight-line method. This method reduces the depreciation charge gradually until it covers the full cost.
For example, an asset worth $ 50,000 with an estimated useful life of 10 years and zero salvage value will have a depreciation charge of $ 5,000 in the first year. It will have a reduced charge of $ 4,500 for the next year, and so on until the full cost is covered.
Sum of the Digits Method
Suppose a firm estimates the useful life of an asset for 5 years. Instead of using the straight-line depreciation line, it can use the sum of the digits formula to charge the depreciation expense.
Sum of the digit useful life = n(n+1)/2
Thus, in our example, the useful life of asset = 5(5+1)/2= 15
This estimate will be then used to calculate the applicable percentage for the depreciation cost for each year.
ASC 360-10-35-4 defines depreciation accounting as:
“a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit in a systematic and rational manner.”
As we can see there are two important determinants in the depreciation accounting for an asset. These are estimating the useful life and the salvage value of an asset.
Estimating the useful life of an asset normally depends on:
- The expected use of the asset
- The expected useful life of another similar asset or a group of assets.
- The effects of demand, competition, obsolescence of the asset.
- The historic treatment method used by an entity for a similar asset in the past.
Similarly, an entity will use rationale estimates for the residual or salvage value of the asset. The salvage value will be considered zero unless the asset has remaining usefulness for another entity.
Journal Entry for Depreciation with Examples
Recording of the depreciation cost in the account books begins with an estimation of the depreciation cost. An entity will determine its preferred depreciation accounting method allowed under its regulatory environment.
There are two main accounts created to record the journal entry for the depreciation charge.
The depreciation expense account is used to charge the depreciation cost of each asset individually. The contra entry for depreciation expense will be the accumulated depreciation account.
The firm can create a depreciation expense account for each fixed asset class separately. Fixed asset depreciation is charged for an asset with a useful life of over one year usually.
Individual depreciation expense account rolls over after each accounting period.
The accumulated depreciation account shows the total depreciation charged for all fixed assets. It is the total non-cash expense that an entity charges against its fixed asset depreciation.
The accumulated depreciation account adjusts after each asset is fully charged for its depreciation.
Recording a Journal Entry
The general journal entry for the depreciation expense can be recorded in the following format.
For individual asset accounts:
|Fixed Asset 1 – Depreciation Expense
|Fixed Asset 2 – Depreciation Expense
|Fixed Asset 3 – Depreciation Expense
|Accumulated Depreciation – Total
Let us consider a few working examples using one of the depreciation calculation methods discussed above.
Suppose a company ABC purchased a new machine worth $ 120,000. The management estimated the useful life of the machine as 10 years. The salvage value is estimated to be $ 25,000 after 10 years of usage.
We’ll apply the straight-line depreciation method to calculate the depreciation charge and its subsequent journal entry.
S. Line Depreciation = 1/no. Of useful life years = 1/10
S. Line Depreciation = 10% per year
Depreciation Expense = (market value – salvage value) × S. Line Depreciation Charge
Depreciation Expense = (120,000 – 25,000) × 10%
Depreciation Expense = $ 9,500
The journal entry will be:
The company ABC will charge the depreciation cost of $ 9,500 for 10 years until it recovers the full cost of the machine $ 95,000.
Suppose the ABC company uses the declining depreciation method instead of the straight-line method.
The declining method uses the same depreciation multiplier as the straight-line method. However, the beginning and ending amounts will change.
Yearly Depreciation Charge = 1/no. Of useful life years = 1/10 = 10%
|Net Book Value at beginning of the year
|Net Book Value at End of the year
|Depreciation Expense Year 1
|Depreciation Expense Year 2
|Depreciation Expense Year 3
|Depreciation Expense Year 4
|Depreciation Expense Year 5
|Depreciation Expense Year 6
|Depreciation Expense Year 7
|Depreciation Expense Year 8
|Depreciation Expense Year 9
|Depreciation Expense Year 10
The journal entry for depreciation expense for ABC company will be different under the declining method.
|Depreciation Expense – Year1
|Depreciation Expense – Year 2
The ABC company will continue to charge the annual depreciation charge until year 10. After that, the company will adjust the accumulated depreciation with the salvage value and the remaining cost of the asset.
As we can see the declining method does not fully cover the depreciation charge by the end of the useful life of the asset. Many businesses use the double-declining method that accelerates the depreciation charge over the useful life of the asset.