Imagine that you own a bakery One day your oven breaks so
you rush out to buy a new one You plug it in or hook it up
whatever you do with ovens and then you're back at it
Mixing, kneading, folding, proofing
Oh.. hey there!
I'm James and this is Accounting Stuff Anyway as time passes your
new oven slowly wears down just like your old one
and eventually it’ll break too This is where depreciation comes in
What is depreciation? It’s the process of reducing the
book value of a tangible fixed asset due to use
wear and tear the passing of time
or obsolescence An asset is something that you own
that’s valuable and which will bring you economic benefit in the future
something like your oven which you’ll use to make money
Your oven is a fixed asset because you'll use it for a long time
and it's a tangible asset because it physically exists
you can touch it you can't touch intangible assets
and they don't depreciate they amortize instead but
that's for another day The book value of your oven is it's
carrying amount in your business's accounts We’ll get into this soon but first
Why do we depreciate? In accrual accounting
revenue is recognized as it's earned and expenses are recorded as they are incurred
With depreciation we're particularly interested in the second line
Expenses are recorded as they are incurred What does this mean for fixed assets
like your oven? Let's say that your oven has a
useful life of 10 years you buy it at the beginning of year 1
and it costs you $8,000 so you physically hand over the cash then
but when do you actually use your oven? Bit by bit over the next 10 years
Depreciation journals are adjusting entries that we post at the end of each
accounting period to bring your books into alignment with the
accrual basis of accounting We do this to make sure that all of your
oven’s use and wear and tear is properly recorded as its incurred
not here when you paid for it but spread out over the next 10 years
How does depreciation work? It begins with buying your oven
if you were using the cash method of accounting
you would expense the entire cost of your oven straight to
your income statement s soon as you hand over the cash
but when you're using the accrual method of accounting
you'd capitalize it instead Capitalization is the process of
recording a cost as a fixed asset in the balance sheet as opposed
to an expense in the income statement so you take up your asset cost of $8,000
and hold it in your balance sheet then over the next 10 years you
gradually write it off releasing it as an expense to your income statement
Now there are a few ways to do this This graph shows the book value
of your oven over time The simplest depreciation method of all
is called straight-line depreciation this is a fixed cost method where the
depreciation expense is spread out evenly over your ovens useful life
but we also have the double declining balance and
sum of the years digits methods These are what we call accelerated
variable cost depreciation methods where the expense is higher in early years
and then we have the units of production method
This is also a variable cost depreciation method but it's not accelerated
Instead the depreciation expense mirrors the actual physical use of your asset
Over the past few weeks I've made videos covering each of these which you can find
in my depreciation playlist I'll link to it down below in the description
along with my depreciation cheat sheet shameless plug
but in this video let's assume that you are using the straight-line method
Here's your completed depreciation schedule This table summarizes the
depreciation expenses accumulated depreciation and
book values of your oven over its useful life You can learn how to make one of these
in my straight-line depreciation video but I'd recommend sticking around
because I'm going to show you how to record all of these transactions
in your business's books How to record depreciation
using journal entries A journal entry is a record
of a financial transaction and to help us figure these out
we'll use DEALER If you've been watching Accounting Stuff
for a while now then you might be familiar with this
but if you haven't then maybe click subscribe Why not?
DEALER is an accounting acronym that stands for
Dividends, Expenses, Assets Liabilities, Equity and Revenue
DEA represent normal debit accounts which means they increase when debited
and decrease when credited LER are normal credit accounts
these do the opposite they increase when credited
and decrease when debited So let's do this
How to capitalize an asset purchase At start of year one you
bought your oven for $8,000 but what's the journal entry?
This is journal number one and as usual it has four columns
Date, the account affected Debits and Credits
You're going to post this in year one to record your asset purchase
but which accounts will be affected? We know that cash needs
to go down by $8,000 Cash is an asset the A in DEALER
so it's a normal debit account which means that debits increase it
and credits decrease it So we'll credit your cash account
by $8,000 to decrease its value in your balance sheet
We're double entry accounting so there are at least two sides
to this transaction what's the other one?
It has to be a debit because total debits need to match total credits
but we can't debit expenses in the income statement
not yet anyway because we're using the accrual method
so we need to capitalize the cost of your oven and hold it
as a tangible fixed asset Assets are normal debit accounts
so we'll debit your baking equipment account by $8,000 to increase
assets in your balance sheet We can see the impact
of this journal on your bakery's books using T accounts
So far you have one for cash and one for baking equipment
A T account is a visual representation of an account where Debits go on the left
and Credits go on the right In journal 1 you credit the right hand side
of your cash account by $8,000 to decrease it and debit the left-hand side
of your baking equipment account by $8,000 to increase it
This is a balance sheet to balance sheet transaction
How to record a depreciation expense using journal entries
During year one you write off $800 as a depreciation expense
to your income statement what does this journal look like?
We know it's going to hit the depreciation expense account
in your income statement Expenses are the first E in DEALER
normal debit accounts which means that debits increase them
So you debit your depreciation expense account by $800 to increase it
in your income statement but where does the other side go?
We need to decrease assets in your balance sheet
so you might think it logical to credit baking equipment
and you're not wrong that would make sense but we don't do that
Instead we're going to credit an account called accumulated depreciation by $800
Accumulated depreciation is the cumulative total of all
depreciation expenses incurred This might take a little bit more effort
but doing it this way helps to keep things organized and
that's a good thing It'll make more sense with T accounts
You'll need two new ones Accumulated depreciation and
depreciation expense In your second journal you debit
depreciation expenses by $800 to increase them in your income statement
and you credit accumulated depreciation by $800
to reduce the value of your oven in the balance sheet
Your baking equipment and accumulated depreciation accounts
both sit in the asset section of your balance sheet
Baking equipment is a normal asset account whereas accumulated depreciation
is what we call a contra asset account What's a contra asset?
It's a normal credit account which contrasts or runs against the flow of normal assets
A Contra Asset If you want to know the book value
of your oven then all you have to do is net these two accounts together
$8,000 - $800 which leaves you with $7,200
in your balance sheet So in year one your cash went down
by $8,000 and baking equipment went up by $8,000
but later on this is offset by an $800 increase in accumulated depreciation
because you've written off $800 as a depreciation expense to your income statement
We can see all of this here in your depreciation schedule
At the end of year one you have $800 in depreciation expenses
$800 in accumulated depreciation and a closing book value of $7,200
Are you still with me? It gets better I promise
We're using the straight-line method which means your depreciation expense
is exactly the same for the next nine years So the next nine journal entries
are identical to the one we just posted each year you debit the
depreciation expense account in your income statement by $800 and
credit accumulated depreciation in your balance sheet by $800
and here's the impact on your books At the start of year one you buy an oven
so your cash went down by $8,000 and your baking equipment went up by $8,000
this is a balance sheet to balance sheet transaction
But during each of the next ten years you post adjusting entries to
record a depreciation expense in your income statement of $800 and
$800 in accumulated depreciation a contra asset account
which offsets the asset cost in your baking equipment account
After ten long years the entire cost of your oven has been written off
to your income statement So if we net together your
baking equipment and accumulated depreciation accounts
we can see that the closing book value of your oven has decreased to zero
which agrees with your completed depreciation schedule
So what's next? Nothing!
Well not exactly if you continue to use your oven
then it will be fully depreciated but you'll still be carrying it in your books
$8,000 in your baking equipment account and $8,000 in accumulated depreciation
but combined a net book value of zero
When you stop using it you'll need to post one more journal entry
Assuming no gain or loss on disposal you'll debit accumulated depreciation
by $8,000 and credit baking equipment by $8,000
This journal clears out all of the older entries in your
baking equipment and accumulated depreciation accounts
leaving you with a balance of zero in each account
But sometimes you might sell your oven and make a gain or loss on disposal
What would happen then? If you'd like me to cover that
then please let me know down below in the comments
don't forget to subscribe for more accounting tutorials
you can find links to my depreciation playlist and depreciation cheat sheet
somewhere on this screen See you soon!