Depreciation is an example of a deferral adjusted entry.
It occurs when cash is paid to acquire long-lived assets
before depreciation expense is incurred.
Let's look at this example:
Assume on January 1,
Morrissey purchases a tour bus for $200,000.
Let's answer the following questions. What is the journal entry on January 1?
Is this an adjusting entry?
And what are the balances on the unadjusted trial balance for equipment, depreciation expense and accumulated depreciation?
The journal entry on January 1, is a debt to the asset account equipment
and a credit to the asset account cash for $200,000.
This is not adjusting entry because there is an underlying transaction that happened on January 1.
Let's learn how to depreciate this bus using the simplest method and then record that in an adjusting entry.
The most common method of depreciation is known as a straight line method.
This method to just spreads the cost of a long lived assets evenly
over the assets useful life.
The formula is: asset cost minus residual value,
or sometimes called salvage value,
divided by the useful life in years.
In our example assume that on January 1 Morrissey purchases a tour bus for 200,000 and the
bus will have a 10 year useful life and no residual value.
That works out to be $20,000 of depreciation expense each year
for 10 years.
So let's make the adjusting entry.
Following the same pattern as our other deferral adjusting journal entries,
we might assume that it is something like what I've shown here:
A debit to depreciation expense and a credit to equipment for $20,000.
But that is not correct for tangible assets with long lives.
A long-term tangible asset, like equipment, still physically exists
after it's been fully depreciated.
This is different than say supplies
which do not exist once they've been fully used up.
Thus, we can not credit the equipment account until that balance is zero.
We need to use a new account called accumulated depreciation.
This account's purpose is exactly what the name describes,
it is the accumulation
of all of the year's depreciation expense.
Accumulated depreciation is a contra-asset account.
This means that is an asset
but it has a normal credit balance
rather than a debit balance like all of our other asset accounts.
This won't be the only contra-account you learn so let's define what makes an account contra.
A contra-account must meet two criteria.
The first is that it must have a companion account.
In this example the companion account is equipment.
For example, if we never owned any equipment,
we would never have an account called accumulated depreciation for equipment.
The second is that it has a normal balance opposite its companion account.
Since equipment has a normal debit balance, accumulated depreciation must have a credit balance.
Finally, lets look at the balance sheet presentation for equipment.
Notice here that accumulated depreciation is deducted from the equipment cost to arrive at a net amount.
We call that net book value.
It's important, you might wanna write it down.
The calculation is cost
minus accumulated depreciation
equals net book value.