Choosing a Method of Depreciation
There are various ways to depreciate an asset and each company must determine which method to use. There are a number of items to consider when making this determination, including ease of calculation, the speed of cost recovery and predictability of the expense.
While all methods are fairly easy to calculate, the units-of-production method is based on usage of the asset and therefore requires usage to be tracked. This would be easy to calculate for a vehicle (mileage) but would be more difficult for a computer. I know I wouldn’t want to track exactly how many hours I used my computer each year, would you?
Most companies consider speed of cost recovery to be the most important consideration because how fast the cost is recovered affects many aspects of business. If the business paid cash for the asset, typically it would like to recover that cost as an expense as quickly as possible. However, if the company financed the asset over a longer period of time, the company may wish to match the cash expenditures of the loan payments to the expensing of the asset.
The speed of cost recovery also affects profit and taxes. A method like straight-line, where the depreciation is the same each year, will cause higher profit in the early years but lower profit in later years when compared to an accelerated method like double-declining balance. Double-declining balance generates a large amount of depreciation in early years of asset ownership, which lowers profit and lowers taxes. Later in the asset’s life, the amount of depreciation is lower than straight-line and causes higher profit and taxes. Some argue that an asset is more efficient when it is newer and generates more revenue, therefore accelerated methods, like double-declining balance, are the way to go. It could also be argued that units-of-production will most closely match revenue because it is based on the output of machinery, equipment and vehicles.
Being able to predict the amount of expense is important to some businesses for consistency in the financial statements. For some companies, that means using straight-line depreciation to evenly depreciate an asset. For some companies, that means using units-of-production to more closely match higher revenue with higher depreciation. Others argue that trying to match cash expenditures and expenses more closely is more consistent and therefore accelerated methods should be used for assets purchased with cash.
As you can see, there are no easy answers when deciding which method of depreciation to use. Luckily, the calculations are much easier than the decision making!
Like most areas of accounting, there are a number of important terms to learn in order to correctly calculate depreciation. It is critical to know these terms and how to apply them to the calculations.
Most depreciation methods use cost in the calculation. Asset cost is the total cost of the asset, including costs to acquire, deliver, and get the asset ready to use. Both straight-line and units-of-production use cost in the calculation. Double-declining balance uses book value rather than cost. Book value is the cost of the asset less any accumulated depreciation on that asset. In the first year, book value is equal to cost because no depreciation has been recorded yet. As depreciation is recorded, the book value of the asset decreases. Book value can also be called basis.
When a company purchases an asset, the company typically has a plan to keep the asset for a certain period of time. At the end of that time, the company will usually sell the asset and use the proceeds toward the acquisition of a new asset. The amount the asset will probably be worth at the end of that time is called salvage value. Because there is value left at the end of the asset’s life, the company should only depreciate the asset so the book value at the end of the life equals the salvage value. Salvage value is not perfect, but it is an estimate at the time of purchase to help minimize gains or losses at the time of sale. Salvage value is used in all depreciation calculations, in one way or another, so that the asset is never depreciated below salvage value.
How long the asset will be useful is the last key to the calculation. Useful life is the period used to depreciate an asset. In most cases useful life is expressed as a measure of time, usually years. In the case of units-of-production, useful life is expressed in a unit of measure associated with the asset. For a vehicle, we typically use mileage when using units-of-production. For a copier, we might use number of copies we expect to be able to make over the life of the copier. For machinery, we could use the expected number of units that could be manufactured with the machine. Useful life has little connection to the actual life of an asset. The Internal Revenue Service has an extensive list of asset lives, which is used by most companies for depreciation purposes. For example, the useful life of a building used in business is 39 years. We all know of perfectly good buildings much older than that!
Calculating Straight-line Depreciation
Straight-line depreciation is the easiest of the three major depreciation methods. This method creates an equal amount of depreciation for each full year. Another perspective is to say that an equal percentage of the asset is depreciated each year. If an asset has a five year life, 20% of the depreciable value would be depreciated each year (100% / 5 years = 20% per year). As discussed earlier, a company cannot depreciate below salvage value; therefore, salvage value is subtracted from the cost of the asset. This depreciable basis is then spread out over the life of the asset to calculate annual depreciation. The formula for calculating straight-line depreciation is:
Annual straight-line depreciation = (cost – salvage value) / life in years
Example #1: On January 1, 2013, Beans R’ Us purchases a van at a cost of $27,000. The company believes the van will have a useful life of five years or 250,000 miles. The salvage value is estimated to be $4,000. Calculate the annual depreciation, using straight-line depreciation, for the five years Beans R’ Us plans to own the vehicle and the journal entry to record the depreciation for 2013.
Since we are using straight-line and the van was purchased on January 1, the depreciation will be the same amount each year. Plug the information given into the formula to calculate the annual depreciation.
($27,000 – $4,000) / 5 =$23,000 / 5 =$4,600 per year
Does this make sense?
At the end of the fifth year, the asset has been depreciated to the point where book value is equal to salvage value. The accumulated depreciation is equal to the depreciable value of the asset. If the company continues to keep the asset, there will be no additional depreciation, unless the company believes that the salvage value has changed.
Using Straight-line Depreciation with a short year
What if the asset as instead purchased on March 1? The depreciation for the first year would be less than $4,600 because the company only owned the van for 10 months. When this is the case, we must adjust the depreciation to reflect the short year. There are a few ways we could do this. We could calculate the monthly depreciation then multiply the monthly amount by the number of months the asset was owned. We could also use a ratio of the number of months owned to the number of months in the year. In this case, the ratio would be 10/12. Either way, you will get the same answer.
$4,600 * 10/12 = $3,833 (rounded to the nearest whole dollar)
This would be the amount of depreciation for the first year. The remaining full years would still be $4,600. Because the van was purchased in March of 2013, we would need to depreciate in January and February of 2018 to record all of the depreciation. Although this is a five-year asset, in order to depreciate five full years, we need six years to do it.
* There are two months of deprecation remaining in 2018. $4,600 * 2/12 = $767 (rounded to the nearest whole dollar). You could also take the book value of $4,767 at the end of 2017 and subtract the salvage value of $4,000, which would also give you $767.
Calculating Units-of-Production Depreciation
Units-of-production is very similar to straight-line, but very rarely used. We are still looking at depreciable value and dividing that amount by the life of the asset. With units-of-production, we are not using years for the life. Instead we use a quantity of units. For vehicles, this quantity is typically mileage. It makes sense because the life of a vehicle is more closely tied to miles driven than age.
Using the depreciable value and units for the life, we can calculate a rate per unit that can then be applied to the actual usage for each year. Because depreciation is based on usage rather than life in years, partial year depreciation is not a factor in units-of-production. If the asset was acquired at any time other than the first of the year, actual activity would reflect that fact. The formula for calculating the rate is very similar to formula used in straight-line.
Depreciation per unit = (cost – salvage value) / life in units
Remember that an asset can never be depreciated below salvage value. This is critically important when using units-of-production because it is very easy to underestimate the life of an asset. If there is more activity than predicted, the company would just stop depreciating once the estimated life in units is reached.
Example #2: On January 1, 2013, Beans R’ Us purchases a van at a cost of $27,000. The company believes the van will have a useful life of five years or 250,000 miles. The salvage value is estimated to be $4,000. The actual miles driven for the first five years are as follows:
Calculate annual depreciation using the units-of-production method for 2013 – 2017.
The first step to solving a problem like this is to calculate the rate that the company will use to apply depreciation. Using the formula above we calculate the rate.
($27,000 – $4,000) / 250,000 = $0.092 per mile
This rate will be used for the life of the asset, unless the company believes that the life will be dramatically increased or decreased. Now that we have the rate, we can apply it to the actual activity for each year to calculate the annual depreciation. When calculating rates, label the rate! In the past, I have had students tell me that the depreciation is $0.092 per year because they did not label the rate and therefore did not apply it correctly. Get in the habit of labeling numbers you calculate.
Although we calculated the 2017 depreciation to be $3,956, that would drop the book value below $4,000 (the salvage value). Therefore, in the fifth year, the depreciation is limited to $2,484. Make sure to watch the accumulated depreciation and book value when doing these calculations so you do not over-depreciate the asset.
Calculating Double Declining Balance
Double declining balance is an accelerated method of depreciation. Companies use double declining balance when they want to quickly depreciate an asset. Those who use the method argue that the value of an asset falls quickly in the first few years and believe that the depreciation method selected should match. It can also be said that companies get more life out of an asset in the first few years of ownership.
The asset will depreciate much faster under this method than straight-line because we double the percentage that would be depreciated each year under straight-line. This does not mean we just calculate straight-line and double it. Instead, we calculate the straight-line percentage and double it. We then multiply that percentage by the book value of the asset. When using double declining balance, do not subtract salvage value when calculating depreciation. However, you must make sure to watch the book value as you do the calculations to ensure you do not depreciate the asset too much.
The formula for double declining balance is:
Annual depreciation = Book value * 100% / life * 2
Annual depreciation = Book value * 200% / life
When doing these calculations, calculate the percentage that should be used first. Once the percentage is calculated, it is the same for the rest of the asset’s life. For a five-year life, the percentage would always be 40% (200% / 5). For a four-year asset, the percentage is 50%. Many of the percentages are easy to calculate in your head.
Example #3: On January 1, 2013, Beans R’ Us purchases a van at a cost of $27,000. The company believes the van will have a useful life of five years or 250,000 miles. The salvage value is estimated to be $4,000. Calculate annual depreciation, using double declining balance, assuming the company plans to keep the vehicle for five years.
Since this asset has a five-year life, the percentage used is 40%. We will multiply the book value by this percentage. Book value in year one is $27,000 because no depreciation has been taken on the asset yet.
$27,000 * 40% = $10,800
As you can see, double declining balance results in a lot more depreciation than straight-line. It is more than twice straight-line because we did not subtract salvage.
When calculating the depreciation for 2014, use the book value of $16,200.
$16,200 * 40% = $6,480
For 2014, the amount of depreciation is significantly less than 2013 but still more than the annual depreciation under straight-line.
Keep running the calculations until you get close to salvage value.
$5,832 * 40% = $2,332.80
The annual depreciation for 2016 is more than the amount of remaining depreciation we are allowed to take on the asset. Therefore, we cannot take the full amount of depreciation calculated. Instead, we are limited to $1,832 in 2016. Since we have hit salvage value, there is no depreciation in 2017.
Because depreciation is accelerated, often the asset finishes depreciating before the end of its life. Make sure to watch book value!
Using Double Declining Balance with a short year
What if the asset was purchased June 1? If that is the case, use the same rules used for straight-line. Calculate the first year’s depreciation and then adjust it based on the number of months the company owned the asset. If the asset was purchased June 1, the company owned the asset for seven months in year 1.
$27,000 * .40 = $10,800 * 7/12 = $6,300
Once you calculate the first year’s depreciation, continue on as normal, depreciating the asset until book value is reached.
For 2017, the amount of depreciation calculated was $1,788.48 but we are limited to $471.20 because of the salvage value.
When completing depreciation calculations, know when to use salvage value in the calculation and always make sure to stop depreciating once you reach salvage value. For partial years, only depreciate for the months that the company owned the piece of equipment. Multiply the annual depreciation by the ratio of months owned to months in the year. This is not necessary for units-of-production since the calculation is based on units rather than time.
Double-declining balance depreciation
Partial year double declining balance depreciation
Units of production depreciation
What are adjusting journal entries?
The matching principle states expenses must be matched with the revenue generated during the period. The purpose of adjusting entries is to ensure that all revenue and expenses from the period are recorded. Many adjusting entries deal with balances from the balance sheet, typically assets and liabilities, that must be adjusted. In addition to ensuring that all revenue and expenses are recorded, we are also making sure that all asset and liability accounts have the proper balances. Adjusting entries are dated for the last day of the period.
When analyzing adjusting entry transactions involving assets and liabilities, remember that you are recording the change in the balance, not the new balance in the account. Ask yourself “what must I do to the account to get the adjusting balance?”
As a business goes through the normal day-to-day operations, many transactions are recorded. When work is done and the company is paid, revenue is recorded. Revenue is also recorded when invoices (accounts receivable) are created. Expenses are recorded when bills (accounts payable) are received. If the company has already recorded all those things, then what could possibly be left to do? You would be surprised!
NOTE: Cash should never appear in an adjusting entry. Most adjusting entries are done after year end and backdated to the end of the year. When cash is spent, the transactions are recorded immediately. With electronic banking, we can instantly check cash transactions. There is no reason why a business shouldn’t know about transactions affecting its cash accounts. Cash is never an account in an adjusting entry.
If a business has done work for a client but has not yet created an invoice, there is unrecorded revenue that must be recorded. Maybe the business just hasn’t gotten around to completing the invoice yet, or maybe the work is partially done but not completely finished. This entry looks exactly like an entry to record work that has been completed but have not yet been paid for.
On December 31, KLI Video Production had completed $3,000 worth of work for clients which has not yet been billed.
Another type of unrecorded revenue deals with work the business was paid for before the work was completed (unearned revenue) which was completed by the end of the period. Transactions of this type can be written two different ways. We could be told how much revenue has been earned or we could be told the remaining balance in unearned revenue. Let’s look at how these transactions could be written so you can see the differences and identify which method to use.
Unearned revenue has an unadjusted balance of $4,000. An analysis of the account shows that $2,500 of the balance has been earned.
When looking at transactions like this one, we need to determine what we are being given. You want to ask yourself if the transaction is giving you the amount of the adjustment (revenue or expense to be recorded) or the adjusted (correct) balance in the asset or liability account. T-accounts are really helpful when doing adjusting entries because you can visualize what is happening. Here is the T-Account for unearned revenue.
We are told the account has an unadjusted balance of $4,000. Unearned revenue is a liability account and therefore the normal balance is a credit. We are told that $2,500 has been earned. Is that the new balance in the account? No, the $2,500 is the amount we need to remove from the account because it is no longer unearned. So if $2,500 is not the balance, then what is the balance? If the business has earned $2,500 of the $4,000, then the new balance is $1,500.
Now we can see the beginning balance and the ending balance in the T-account. Now, we have to determine how to get there. If we have a $4,000 credit balance and then have a $1,500 credit balance, the balance decreased by $2,500. How do we decrease an account with a credit balance? We debit the account. The $2,500 was given in the transaction, but now we know what to do with it. If you can predict what the balance should be in the account, you can do a T-account to make sure your entry will actually do what you predicted.
The credit in the entry is fees earned (revenue) because we were told that $2,500 had been earned. When you see earned, you should always think revenue unless the transaction states the money has not yet been earned. That statement should make you think of unearned revenue because it has not been earned.
The company had an unadjusted balance in unearned revenue of $4,000. An analysis of the account shows $1,500 is still unearned.
This transaction is worded a bit differently than the last. This transaction tells you what the ending balance in the account should be. Using a T-account in this scenario is a smart idea.
Notice, this example is exactly the same as Example #2. In order to get the balance from $4,000 credit to $1,500 credit, we need to debit unearned revenue $2,500.
Make sure to watch the wording in all adjusting entry transactions to ensure you understand what information you have.
Typically, when we are looking for unrecorded expenses, we look to the balance sheet. There are two types of unrecorded expenses: those that are related to assets that have been used up or need to be adjusted and those related to unrecorded liabilities.
Assets and Expenses
The definition of an asset is something the company owns or has the right to which it can use to generate revenue. When we were recorded journal entries, we recorded transactions to various asset accounts that when used up, will generate an expense. Some of those accounts were supplies, prepaid expenses and long-term asset accounts, like equipment and buildings.
Supplies are initially recorded as an asset, but they get used up over time. Rather than record an entry every time a ream of paper or a bag of mulch is removed from storage, we do an adjusting entry at the end of the period to record the amount of supplies that have been used up. Recording an entry every time something is removed from the stockroom or garage would violate the cost-benefit constraint. At the end of the period, the company counts up what is left for supplies. The difference between the balance in the account (unadjusted) and the amount that is left (adjusted) is the value used in the journal entry.
The balance in the supplies account at the end of the year was $5,600. A count of supplies shows that $1,400 worth of supplies are still on hand.
What does this transaction tell us? The unadjusted supplies balance is $5,600 but the adjusted balance should be $1,400. The transaction does not tell us the amount of the adjustment. That is something we will need to figure out. You may want to draw up a quick T-account to visualize the transaction.
To decrease the account balance, which is a debit balance, we need to credit the account. How much will we need to credit the account? What amount will bring the balance from $5,600 to $1,400? The difference is $4,200. So we need to credit the supplies account $4,200.
Where did the supplies go? They were used it. We call this supplies expense. Now we can write the journal entry.
Use the same methodology when doing entries involving prepaid expenses. Draw a T-account to help visualize what is happening.
Long-term assets and Expenses
When a company purchases a long-term asset, such as a vehicle to use in its business, we record the entire value of the purchase as an asset. That vehicle is used to generate revenue so shouldn’t that vehicle somehow be expensed? Yes, it should be. We call the expensing of a long-term asset depreciation. Do not confuse depreciation in accounting with how the term is used outside of accounting. Typically, we think of depreciation as a decline in market value. For example, I have heard it said many time that when you purchase a new car, it depreciates or loses 20% of its value when you drive off the lot. Depreciation in accounting has nothing to do with market value. Depreciation represents the using up of an asset to generate revenue.
The cost principle states that we must record assets at cost. In order to maintain that principle, when we record depreciation expense (which is a debit in the journal entry), we do not credit the asset directly. Instead we will use a contra account. A contra account is an account linked to another account but which has a normal balance opposite to the account it is linked to. A contra asset account would be linked to a specific asset account but would have a credit balance. For the vehicle described above, we would have a contra asset account called accumulated depreciation. This account would be linked to the vehicles account and would have a credit balance.
Some companies have one accumulated depreciation account used for all long-term assets and others have a separate accumulated depreciation account for each long-term asset account. In the next example, we will assume there is one accumulated depreciation account.
The company calculates that the current year depreciation is $12,000.
As with all adjusting entries, we need to determine if we are being given an account balance (asset or liability) or the amount of the expense. In this case, as with all depreciation entries, we are given the amount of the expense. Therefore, there is nothing to calculate here. No T-account is needed.
For more information about long-term assets and depreciation, see the posts on long-term assets and calculating depreciation.
Adjusting Entries Involving Liabilities
Some adjusting entries involve expenses that have not yet been paid for nor has the obligation been recorded. However, in these cases an expense has been generated. Examples include unrecorded bills and unpaid wages, interest, and taxes. This is not an exhaustive list but it does cover most of the transactions you will see. These entries require the recording of an expense and a liability.
The company received a bill for December’s utilities on January 5. The bill was for $235.
Although the bill was received in January, the utilities were used in December to generate revenue in December. The matching principle tells us that we must record the utilities expense in December.
The company pays its employees every two weeks. On December 31, the employees had worked four days for which they had not been paid. The amount due to the employees was $4,300.
Are you thinking matching principle here? Our employees help us generate revenue. The wages that we pay them must be matched to the revenue they are creating. Therefore, the $4,300 must be recorded in December. The wages have not been paid so we must show a liability. The liability used in this case will be wages payable.
Note: Accounts payable should only be used for routine bills (utilities, supply and inventory purchases). Other short-term payables should be named based on the expense they are related to. That is why wages payable was used in this case.
The company has a long-term note payable with Ginormic National Bank. As of December 31, $670 of interest had accrued on the loan but had not yet been paid.
Why do we have to record this? First, the interest is an expense for December even though it has not yet been paid. Second, to be accurate in our financial statements, the balance owed to the bank on December 31 includes not only the balance on the loan but also the unpaid interest. If we contact Ginormic National Bank to payoff the loan on December 31, we would need to pay the principal owed plus the $670 of interest. The interest is considered a separate payable and should not be added to the note payable.
The company estimates its profit to be $42,000 for the year and is in a 35% tax bracket.
When reading this transaction, it doesn’t even sound like something we would need to record. It just sounds like a statement, but the matching principle should set off an alarm. Why are we paying income taxes? The company had a profit for the year of $42,000. Income taxes are an expense of doing business. Should the expense fall in the year that is completed or the year we are currently in? The expense is related to the year that is completed and, therefore, must be recorded as an adjusting entry.
To figure out how much to record for taxes, we need to calculate 35% of the profit, which would be $14,700 ($42,000 x 0.35). Now we can record the entry.
Things to Remember
Treat adjusting entries just like you would treat normal entries. Use these steps when completing adjusting journal entries.
- Read the transaction to determine what is going on. Is an entry required?
- Identify the accounts you will use in your entry. Remember, cash is never used in adjusting entries!
- Determine the amount. Did the transaction give you the amount to use or do you need to calculate it? T-accounts are helpful here.
- Determine which account(s) to debit and which account(s) to credit.