Introduction:
The decrease in the value of an asset due to wear and tear is called depreciation. According to International Accounting standards, all the Fixed Assets should have an estimated useful life.
And the firms should divide the cost of an asset on its life cycle. Accounting standards do not allow you to expense all the cost of an asset in a one-year profit & loss statement.
In a double-entry system, depreciation expense is determined by dividing the cost of an asset by the estimated useful life of an asset. There are many methods for calculating depreciation expenses but the famous areas.
- By straight line method
- Double Declining Method
- Units of Production
- Sums of Years Digit
Most of the firms use the straight-line method for depreciation purposes. As it is easy to calculate with a constant effect on the income statement. The other methods are also used by some organizations, but their use is much lower than the first one.
How Depreciation Expense is Calculate by using straight line method:
As the name suggests the expense is calculated on a straight line. Let have a look at the formula so you can understand it better
Depreciation Expense= (Cost of Asset-Residual Value)/ Estimated life of Asset.
Two methods are again used to record depreciation. In the first method after the completion of the financial period, the depreciation expense is subtracted from the Asset value and charged to the income statement for the year.
Depreciation Expense Dr
Asset Value Cr
Income Statement A/C Dr
Depreciation A/C Cr
In this method, the value of the asset is recorded as the net amount in the balance sheet. This method is not preferred by the International Accounting Standards.
In the other method of recording depreciation, an account in the name of accumulated depreciation is created. This account is used to accumulate the total depreciation throughout the life of an asset.
If there is an estimated residual value for an asset, then the carrying amount at the end of its life cycle should be equal to its residual value.
On the first year of Acquisition of Asset the entry will be:
Depreciation Expense Dr
Accumulated Depreciation Cr
In the second year, the next depreciation expense will be added with the previous balance in the accumulated depreciation account. The entry will be as follows
Depreciation Expense Dr
Accumulated Depreciation Cr
This entry will add the current year’s depreciation expense with the previous year’s closing balance. And this process will be carried on till the life of the asset.
Now there will be an adjusting entry if the depreciation expense is charged less or more due to any reason. If the depreciation is previously charged less from the original, then the entry should be
Depreciation expenses Dr
Accumulated Expenses Cr
And if the Depreciation is charged at a high rate than the estimated rate then the adjusting entry should be
Accumulated Depreciation Dr
Depreciation expense Cr
Now look at the example:
If the depreciation expenses were recorded amount of $7,500 while the correct depreciation during the period should be charged only amounted to $9,000. Therefore, the $1,500 adjusting entry should be made to rectify the amount of accumulated depreciation account.
The accounts to be affected by this adjustment are the accumulated depreciation and depreciation account. Accumulated depreciation is the balance sheet item account while depreciation is the income statement account.
The above error results in undercharged depreciation expenses during the period; therefore, the depreciation expenses amount to $1,500 should be added on and the accumulated depreciation amount should be subtracted from.
This adjustment will increase depreciation expenses in the income statement and reduce the varying value or netbooks value of fixed assets in the balance sheet through increasing accumulated depreciation.
Here is what the adjustment will look like;
Depreciation Expense $1,500
Accumulated Depreciation $1,500
Noted:
Depreciation Expense (Income Statement)
Accumulated Depreciation (Balance Sheet)
