How to Record Journal Entries for Depreciation?

How to Record Journal Entries for Depreciation

Loading

Last Updated on March 23, 2024 by Qusai Ahmad

Depreciation is the process of allocating the cost of a long-term asset over its useful life. It reflects the fact that assets lose value over time due to wear and tear, obsolescence, or other factors. Depreciation is an important concept in accounting, as it affects the income statement, the balance sheet, and the cash flow statement. and in this blog post we will go through the Journal Entries for Depreciation.

How to Record Depreciation

Depreciation is recorded as an expense on the income statement, reducing the net income and the earnings per share. However, depreciation does not affect the cash flow of the business, as it is a non-cash expense. Therefore, depreciation is added back to the net income in the cash flow statement, increasing the operating cash flow.

To record depreciation, a journal entry is made at the end of each accounting period, debiting the depreciation expense account and crediting the accumulated depreciation account. The depreciation expense account is an income statement account, while the accumulated depreciation account is a contra-asset account that reduces the carrying value of the asset on the balance sheet.

The journal entry for depreciation can be written as:

Depreciation Expense     Dr    XXX
  Accumulated Depreciation    Cr    XXX

Where XXX is the amount of depreciation for the period.

How to Calculate Depreciation

There are different methods of calculating depreciation, depending on the nature of the asset and the preference of the business. Some of the common methods are:

    • Straight-line method: This method allocates the same amount of depreciation every year, based on the original cost, the salvage value, and the useful life of the asset. The formula for the annual depreciation expense is:
Straight-line method
    • Units-of-production method: This method allocates depreciation based on the actual usage or output of the asset, rather than the passage of time. The formula for the depreciation expense per unit is:
Units-of-production method

The total depreciation expense for the period is then calculated by multiplying the depreciation expense per unit by the number of units produced or used in the period.

    • Double-declining balance method: This method allocates more depreciation in the earlier years of the asset’s life, and less in the later years. It is based on the assumption that the asset loses more value in the beginning, due to rapid obsolescence or deterioration. The formula for the annual depreciation rate is:
Double-declining balance method

The depreciation expense for each year is then calculated by multiplying the depreciation rate by the book value of the asset at the beginning of the year. The book value is the original cost minus the accumulated depreciation.

Example of Journal Entries for Depreciation

Let’s assume that a company purchases a machine for $10,000, with a salvage value of $1,000 and a useful life of 5 years. The company uses the straight-line method of depreciation. The annual depreciation expense is:

Journal Entries for Depreciation

The journal entry for the first year of depreciation is:

Depreciation Expense     Dr    1,800
  Accumulated Depreciation    Cr    1,800n

The journal entry for the second year of depreciation is:

Depreciation Expense     Dr    1,800
  Accumulated Depreciation    Cr    1,800

And so on, until the fifth year, when the book value of the asset becomes equal to the salvage value.

The effect of these journal entries on the financial statements is:

    • The income statement shows a depreciation expense of $1,800 every year, reducing the net income and the earnings per share.
    • The balance sheet shows the machine as an asset with a cost of $10,000 and an accumulated depreciation of $1,800 in the first year, $3,600 in the second year, and so on, until $9,000 in the fifth year. The net book value of the machine is $10,000 – $1,800 = $8,200 in the first year, $10,000 – $3,600 = $6,400 in the second year, and so on, until $10,000 – $9,000 = $1,000 in the fifth year.n
    • The cash flow statement shows the purchase of the machine as a cash outflow of $10,000 in the investing activities section, and the depreciation expense as a non-cash adjustment of $1,800 every year in the operating activities section, increasing the operating cash flow.

Advantages and Disadvantages of Depreciation

Depreciation has some advantages and disadvantages for the business, depending on how it is used and reported. Some of the advantages are:

    • Tax benefits: Depreciation reduces the taxable income of the business, lowering the tax liability and increasing the after-tax cash flow.
    • Matching principle: Depreciation matches the cost of the asset with the revenue generated by the asset over its useful life, following the accounting principle of matching expenses with revenues.
    • Asset replacement: Depreciation helps the business plan for the replacement of the asset when it reaches the end of its useful life, by setting aside funds from the depreciation expense.

Some of the disadvantages are:

    • Overstatement of net income: Depreciation is based on estimates and assumptions, which may not reflect the actual market value or economic life of the asset. This may result in overstating the net income and the return on assets of the business, misleading the investors and creditors.
    • Understatement of asset value: Depreciation reduces the book value of the asset on the balance sheet, which may not reflect the fair value or the resale value of the asset. This may result in understating the total assets and the equity of the business, affecting the financial ratios and the credit rating.
    • Complexity and inconsistency: Depreciation involves choosing a method, a rate, a salvage value, and a useful life for each asset, which may vary from one business to another, or from one period to another. This may create complexity and inconsistency in the accounting and reporting of depreciation, making it difficult to compare the financial performance and position of different businesses.

Summary and Takeaways

In this blog post, we have learned about the concept of depreciation, how to record it in journal entries, how to calculate it using different methods, and what are the advantages and disadvantages of depreciation for the business. Here are some key takeaways from this post:

    • Depreciation is the process of allocating the cost of a long-term asset over its useful life, reflecting the loss of value due to wear and tear, obsolescence, or other factors.
    • Depreciation is recorded as an expense on the income statement, reducing the net income and the earnings per share, and as a contra-asset on the balance sheet, reducing the book value of the asset.
    • Depreciation does not affect the cash flow of the business, as it is a non-cash expense. Therefore, depreciation is added back to the net income in the cash flow statement, increasing the operating cash flow.
    • There are different methods of calculating depreciation, such as the straight-line method, the units-of-production method, and the double-declining balance method. Each method has its own assumptions and implications for the financial statements and the tax benefits of the business.
    • Depreciation has some advantages, such as lowering the tax liability, matching the expenses with the revenues, and planning for the asset replacement, and some disadvantages, such as overstating the net income, understating the asset value, and creating complexity and inconsistency in the accounting and reporting.

We hope you found this blog post informative and helpful. If you have any questions or comments, please feel free to leave them below. We would love to hear from you. Thank you for reading.

Leave a Comment

Your email address will not be published. Required fields are marked *