Many businesses own assets that lose their value, or depreciate, over time.
Like all activity that is associated with the exchange of monetary value, depreciation must be correctly recorded in the business’s accounting ledgers.
The initial recording would be made in the form of a depreciation journal entry.
An asset is any resource that has monetary value, however, depreciation applies only to what are referred to as fixed assets or tangible assets. Fixed assets are physical and they must last at least one year.
They are purchased and owned by the business to support its operations. They may also be referred to as capital assets.
There are many examples of fixed assets. They include a variety of property and other forms of physical resources, such as buildings, equipment, machinery, tools, vehicles, computers, and furniture.
In contrast, items such as cash and accounts receivable are considered short-term assets because they are liquid, meaning they can be converted to cash in less than a year.
Intangible assets, such as a brand or a customer database, are items that give the business value, but are also not considered physical or fixed.
Neither short-term nor intangible assets lose their value over time, so the process of depreciation does not apply to them.
Only fixed assets have the unique characteristic of losing value over time. They lose value either from wear and tear from use, as in the case of a vehicle, or from becoming outdated as advances in technology renders them less useful, as in the case of computer equipment.
This loss in value must be accurately recorded so it can be properly factored into the business’s total, or net, asset calculations.
Depreciation is recorded in the business’s accounting ledgers like any other financial activity. However, it has its own unique method of recording.
Depreciation journal entries are designed to properly record the value and the cost of an asset over its useful life.
To do this, a number of unique steps are taken.
Most businesses follow a method of accounting known as the Generally Accepted Accounting Principles (GAAP). These include the so-called matching principle.
The matching principle requires all revenue and related expenses to be recorded in the same accounting period when the transaction occurs, regardless of when money changes hands.
This helps the business arrive at a more accurate accounting of its income and related expenses.
According to the matching principle, the depreciation of an asset must be recorded as an expense in the same accounting periods when that asset is earning revenue for the business that owns it.
Businesses also follow the double-entry system of accounting, which holds that every transaction has an equal and opposite effect in at least two different places. According to the double-entry system, entries will also be made in a so-called contra asset account.
Contra accounts are used in the general ledger to offset the value of another corresponding account.
Based on the two principles, when an asset is first purchased by a business, it will be recorded at its full value as a debit in the asset account and as a credit to the cash account for the cost of its purchase.
Depreciation journal entries will be recorded as debits in the expense account. This will offset any revenue that is generated by the asset and will show up in the income statement.
The depreciation journal entries in the contra asset account will be cumulative, which means that over time they will add up until they offset the total original value of the asset.
Because the original fixed asset was recorded as a debit in the asset account, the accumulated depreciation will be recorded as a credit. The fixed asset and the accumulated depreciation will show up in the business’s balance sheet.
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Depreciation is generally calculated based on these basic values:
The original cost of the asset or its “basis” reflects all the costs to purchase the asset and put it to use for the business.
A business will use one of two depreciation methods. The straight-line method calculates the depreciation at the same rate over time.
The accelerated depreciation method calculates a faster rate of depreciation in the early life of the asset, which is beneficial for tax purposes.
A business must determine the useful life of the asset, which will vary depending on the type of asset, or asset class.
Finally, accountants will determine the residual value or salvage value of the asset, which is what the asset will likely sell for at the end of its useful life. Often this will be equal or close to zero.
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This provides a complete journal entry management system that enables accountants to create, review, and approve journals, then electronically certify and store them with all supporting documentation.
By automating journal entries, organizations have cut time and effort around journal entry processing by as much as 90%.
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