How to calculate Depreciation (Balance Day Adjustment)
Earlier we discussed the term capital expenditure. Let’s explore this a little further.
Capital expenditure is when you purchase an asset. It might be a car, a house, a merry-go-round for your daughter, maybe even a submarine to use as your secret lab. Whatever it is, we label it as capital expenditure rather than an expense.
An easy way to think of it is, an expense is when you purchase something you use up in less than a year, whereas an asset is something that lasts for more than a year.
Now, assets don’t last forever. When you buy a car for $5,000, it’s worth $5,000.
But what about the next year? Because you drive it every day, leave pizza in the back seat and draw smiley faces on the windows, the value goes down. Perhaps you can only sell it for $4,000 after a year. After three years, it might only be worth $1,500! This gradual reduction in value is called depreciation. We normally calculate depreciation on balance day, which is the last day of the financial year. For this reason, depreciation is known as a balance day adjustment.
So how do we account for depreciation?
The most common method is called the straight line method.
The Straight Line Method
Let’s look at an example:
Let’s say you decide to buy a secret underwater submarine lab. You purchase the most beautiful submarine you’ve ever seen for $100,000. However, you know that in 5 years of time, the submarine will only be worth $20,000.
The straight line method assumes that the asset will depreciate by the same amount each year until it reaches its residual value. The residual value is how much it will be worth at the end of its life. In this case, we know this amount is $20,000. That means the submarine is going to depreciate by $80,000 over 5 years.
Let’s work that out using some simple maths we learned back in elementary school.
$80,000 / 5 years = $16,000 per year
Now we have our answer. The submarine will depreciate by $16,000 every year for 5 years. After 5 years it will have depreciated in value by $80,000, leaving it with a residual value of $20,000.
Perfect. Let’s have a go using one of our bakery examples.
Remember the car we bought from John’s Car Shop? If I remember correctly, it was a green lotus, and it cost $3,000.
Now John tells us that in 5 years we’ll be able to sell that car for $1,000.
We now have all the information we need to work out for our car’s depreciation.
Value at time of purchase: $3,000
Value in 5 years time: $1,000
Amount to be depreciated (HINT: Initial value minus residual value): $2,000
Depreciation per year: $400
Interactivity:
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Enter value at time of purchase: |
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Great, so we now know that we will be depreciating our car at $400 per year. Now although there is no cash involved, these are still transactions. That means they have a journal entry and need to be entered into a ledger!
Depreciation is an EXPENSE. Therefore, we are going to create a depreciation expense account, which is a debit account.
Accumulated depreciationis a term we haven’t come across yet. Accumulated depreciation, as the name suggests, is the total amount of depreciation that has built up over the years. For example, if our asset depreciates by $100 for each of the last 3 years, our accumulated depreciation will be $300.
Accumulated Depreciation is a LIABILITY.
Therefore, we’re going to create an Accumulated Depreciation account that will sit on the credit side of our accounting equation.
To record the depreciation for the year, we’ll need to prepare a journal entry. Here’s what the journal entry looks like:
|
Dr |
Depreciation expense |
$400 |
|
Cr |
Accumulated depreciation |
$400 |
Now it’s your turn. Enter this journal into the following ledgers and calculate the balance.
DEPRECIATION EXPENSE
- Opening Balance
- Accumulated Depreciation
- 0
- 400
- Depreciation
- Bank
- car
|
detail |
debit |
credit |
|
|
|
|
|
|
|
ACCUMULATED DEPRECIATION
- Opening Balance
- Accumulated Depreciation
- 0
- 400
- Depreciation
- Bank
- car
|
detail |
debit |
credit |
|
|
|
|
|
|
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Diminishing value method
Another common method of depreciation is the diminishing value method.
When using this method, assets do not depreciate by an equal amount each year. Rather, depreciation is recalculated each year based on the assets depreciated value or ‘book value’. This is best illustrated in an example:
Remember our car from John’s Car Shop? It cost $3,000, and we were told it would last for 5 years.
With this method we need to estimate the amount of depreciation we expect it to have. For the purpose of this example, let’s say 20% per year.
Year 1:
The value of our car is $3,000, and it’s going to depreciate by 20%.
20% of $3,000 is $600.
We’ve now worked out our first year’s depreciation! Here’s what the journal entry will look like:
|
Dr |
Depreciation expense |
$600 |
|
Cr |
Accumulated depreciation |
$600 |
Have a go at entering this journal entry into the ledger below:
DEPRECIATION EXPENSE
|
Details |
DEBIT |
CREDIT |
|
Opening balance |
$0 |
|
|
Accumulated Depreciation |
$600 |
|
|
|
|
|
|
BALANCE |
$600 |
|
|
Details |
DEBIT |
CREDIT |
|
Opening balance |
|
$0 |
|
Depreciation |
|
$600 |
|
|
|
|
|
BALANCE |
|
$600 |
Year 2:
We are now looking to depreciate our car for the second year. Our car was originally valued at $3,000.
However, when using this method we calculate depreciation based on the car’s current value, not original value.
We already depreciated our car by $600 in the first year (above). This means the current value of our car is considered to be $2,400 ($3,000 - $600 = $2,400).
This is the value we’ll use to calculate this year’s 20% depreciation:
20% of $2,400 comes to$480. This will be the amount of depreciation for our car this year.
Here’s what the journal entry will look like:
|
Dr |
Depreciation expense |
$480 |
|
Cr |
Accumulated depreciation |
$480 |
Have a go at entering this journal entry into the ledger below:
DEPRECIATION EXPENSE
|
Details |
DEBIT |
CREDIT |
|
Opening balance |
$0 |
|
|
Accumulated Depreciation |
$480 |
|
|
|
|
|
|
BALANCE |
$480 |
|
ACCUMULATED DEPRECIATION.
|
Details |
DEBIT |
CREDIT |
|
Opening balance |
|
$600 |
|
Depreciation |
|
$480 |
|
|
|
|
|
BALANCE |
|
$1080 |
Notice how in this second year our depreciation expense ledger has an opening balance of $0 whereas our accumulated depreciation ledger has an opening balance of $600.
This is because depreciation expense is recalculated every year. It is an expense account, and the nature of expenses is that they only relate to the year in which they are calculated. At the end of the year, they restart back at zero.
On the other hand, accumulated depreciation represents the depreciation from all previous years added together; hence the name ‘accumulated’ depreciation. It is a liability, and the nature of liabilities is that their value carries forward year after year.
In the real world, we would be depreciating all our assets. That is, we would also need to work out depreciation on our oven, our computer and our iPhone. For the sake of keeping things as simple as possible, we’ll let that side for now. The purpose of this lesson was to simply explain the concept of depreciation and how we record it.
Alright, let’s move on!
NOTE: Usually it’s the government that prescribes the depreciation rates for different asset class.