Financial Accounting/Depreciation

Required Readings

 * Matching Principle
 * Depreciation
 * Amortization
 * Residual Value
 * Useful Life
 * Amortization vs. Depreciation

Summary

 * Depreciation is the regular reduction in value of a fixed asset. Since the entry must be two sided, the entry is to debit depreciation expense and credit the accumulated depreciation. The net of the cost of the asset and accumulated depreciation is the net value of the asset.
 * The most common method of depreciation is straight-line depreciation. This method credits the asset by an equal amount over the asset's useful life.
 * The residual value must be subtracted from the initial cost to determine the amount to expense each period. So the equation looks like this:

Cost of asset - Residual Value Depreciation expense = -- Useful life


 * The net value on the balance sheet of an asset is not meant to reflect it's fair value (the value it could be sold for). Depreciation is a method of spreading the assets cost over several periods on the income statement and does not necessarily reflect its usage pattern. If this were not the case, companies could appear unprofitable in years of large investments such as the purchase of land and building even though those investments are meant to benefit the company over a longer period of time. This is a key component to accounting called the matching principle.

Examples
We will go over a few examples to illustrate how these depreciation entries work.


 * Sherry buys a lawnmower with her own cash for $500 to start a lawn-care business:

ASSETS                            |                   LIABILITIES |        CASH                ACCOUNTS RECEIVABLE     |     ACCOUNTS PAYABLE            LOAN --       ---     |                       |                          |               |            |                     |          |                          |               |            |                     |           |                          |               |            |                     |          |                          |               |            |                     |                                                     |      LAWNMOWER         ACCUMULATED DEPRECIATION     |                  EQUITY --      ---      |       500|                        |                 |     RETAINED EARNINGS       OWNER'S EQUITY |                       |                 |    ---     ---          |                        |                 |            |                      |500          |                        |                 |            |                      |                                                     |            |                      |                                                     |            |                      | ____________________________________________________|__________________________________________________                    EXPENSES                         |                   REVENUE |        FUEL                   DEPRECIATION         |          SALES -                ---          |         ---          |                          |               |            |          |                          |               |            |          |                          |               |            |          |                          |               |            |                                                     |


 * Sherry estimates that the lawnmower will last 5 years and she will be able to sell it after 5 years for $200. Her depreciation expense is ($500 - $200) / 5 years = $60. Let's make our depreciation entry:

ASSETS                            |                   LIABILITIES |        CASH                ACCOUNTS RECEIVABLE     |     ACCOUNTS PAYABLE            LOAN --       ---     |                       |                          |               |            |                     |          |                          |               |            |                     |           |                          |               |            |                     |          |                          |               |            |                     |                                                     |      LAWNMOWER         ACCUMULATED DEPRECIATION     |                  EQUITY --      ---      |       500|                        |60               |     RETAINED EARNINGS       OWNER'S EQUITY |                       |                 |    ---     ---          |                        |                 |            |                      |500          |                        |                 |            |                      |                                                     |            |                      |                                                     |            |                      | ____________________________________________________|__________________________________________________                    EXPENSES                         |                   REVENUE |        FUEL                   DEPRECIATION         |          SALES -                ---          |         ---          |                        60|               |            |          |                          |               |            |          |                          |               |            |          |                          |               |            |                                                     |


 * At the end of the first year, the net value of the lawnmower is $440 on the balance sheet. This same entry will take place in year two resulting in a net asset value of $380 at the end of year 2.

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