DEPRECIATION BASICS! With Journal Entries

Imagine that you own a bakery One day your oven breaks so you rush out to buy a new one You plug it in or hook it up whatever you do with ovens and then you're back at it Mixing, kneading, folding, proofing Oh.. hey there! I'm James and this is Accounting Stuff Anyway as time passes your new oven slowly wears down just like your old one and eventually it’ll break too This is where depreciation comes in What is depreciation? It’s the process of reducing the book value of a tangible fixed asset due to use wear and tear the passing of time or obsolescence An asset is something that you own that’s valuable and which will bring you economic benefit in the future something like your oven which you’ll use to make money Your oven is a fixed asset because you'll use it for a long time and it's a tangible asset because it physically exists you can touch it you can't touch intangible assets and they don't depreciate they amortize instead but that's for another day The book value of your oven is it's carrying amount in your business's accounts We’ll get into this soon but first Why do we depreciate? In accrual accounting revenue is recognized as it's earned and expenses are recorded as they are incurred With depreciation we're particularly interested in the second line Expenses are recorded as they are incurred What does this mean for fixed assets like your oven? Let's say that your oven has a useful life of 10 years you buy it at the beginning of year 1 and it costs you $8,000 so you physically hand over the cash then but when do you actually use your oven? Bit by bit over the next 10 years Depreciation journals are adjusting entries that we post at the end of each accounting period to bring your books into alignment with the accrual basis of accounting We do this to make sure that all of your oven’s use and wear and tear is properly recorded as its incurred not here when you paid for it but spread out over the next 10 years How does depreciation work? It begins with buying your oven if you were using the cash method of accounting you would expense the entire cost of your oven straight to your income statement s soon as you hand over the cash but when you're using the accrual method of accounting you'd capitalize it instead Capitalization is the process of recording a cost as a fixed asset in the balance sheet as opposed to an expense in the income statement so you take up your asset cost of $8,000 and hold it in your balance sheet then over the next 10 years you gradually write it off releasing it as an expense to your income statement Now there are a few ways to do this This graph shows the book value of your oven over time The simplest depreciation method of all is called straight-line depreciation this is a fixed cost method where the depreciation expense is spread out evenly over your ovens useful life but we also have the double declining balance and sum of the years digits methods These are what we call accelerated variable cost depreciation methods where the expense is higher in early years and then we have the units of production method This is also a variable cost depreciation method but it's not accelerated Instead the depreciation expense mirrors the actual physical use of your asset Over the past few weeks I've made videos covering each of these which you can find in my depreciation playlist I'll link to it down below in the description along with my depreciation cheat sheet shameless plug but in this video let's assume that you are using the straight-line method Here's your completed depreciation schedule This table summarizes the depreciation expenses accumulated depreciation and book values of your oven over its useful life You can learn how to make one of these in my straight-line depreciation video but I'd recommend sticking around because I'm going to show you how to record all of these transactions in your business's books How to record depreciation using journal entries A journal entry is a record of a financial transaction and to help us figure these out we'll use DEALER If you've been watching Accounting Stuff for a while now then you might be familiar with this but if you haven't then maybe click subscribe Why not? DEALER is an accounting acronym that stands for Dividends, Expenses, Assets Liabilities, Equity and Revenue DEA represent normal debit accounts which means they increase when debited and decrease when credited LER are normal credit accounts these do the opposite they increase when credited and decrease when debited So let's do this How to capitalize an asset purchase At start of year one you bought your oven for $8,000 but what's the journal entry? This is journal number one and as usual it has four columns Date, the account affected Debits and Credits You're going to post this in year one to record your asset purchase but which accounts will be affected? We know that cash needs to go down by $8,000 Cash is an asset the A in DEALER so it's a normal debit account which means that debits increase it and credits decrease it So we'll credit your cash account by $8,000 to decrease its value in your balance sheet We're double entry accounting so there are at least two sides to this transaction what's the other one? It has to be a debit because total debits need to match total credits but we can't debit expenses in the income statement not yet anyway because we're using the accrual method so we need to capitalize the cost of your oven and hold it as a tangible fixed asset Assets are normal debit accounts so we'll debit your baking equipment account by $8,000 to increase assets in your balance sheet We can see the impact of this journal on your bakery's books using T accounts So far you have one for cash and one for baking equipment A T account is a visual representation of an account where Debits go on the left and Credits go on the right In journal 1 you credit the right hand side of your cash account by $8,000 to decrease it and debit the left-hand side of your baking equipment account by $8,000 to increase it This is a balance sheet to balance sheet transaction How to record a depreciation expense using journal entries During year one you write off $800 as a depreciation expense to your income statement what does this journal look like? We know it's going to hit the depreciation expense account in your income statement Expenses are the first E in DEALER normal debit accounts which means that debits increase them So you debit your depreciation expense account by $800 to increase it in your income statement but where does the other side go? We need to decrease assets in your balance sheet so you might think it logical to credit baking equipment and you're not wrong that would make sense but we don't do that Instead we're going to credit an account called accumulated depreciation by $800 Accumulated depreciation is the cumulative total of all depreciation expenses incurred This might take a little bit more effort but doing it this way helps to keep things organized and that's a good thing It'll make more sense with T accounts You'll need two new ones Accumulated depreciation and depreciation expense In your second journal you debit depreciation expenses by $800 to increase them in your income statement and you credit accumulated depreciation by $800 to reduce the value of your oven in the balance sheet Your baking equipment and accumulated depreciation accounts both sit in the asset section of your balance sheet Baking equipment is a normal asset account whereas accumulated depreciation is what we call a contra asset account What's a contra asset? It's a normal credit account which contrasts or runs against the flow of normal assets A Contra Asset If you want to know the book value of your oven then all you have to do is net these two accounts together $8,000 - $800 which leaves you with $7,200 in your balance sheet So in year one your cash went down by $8,000 and baking equipment went up by $8,000 but later on this is offset by an $800 increase in accumulated depreciation because you've written off $800 as a depreciation expense to your income statement We can see all of this here in your depreciation schedule At the end of year one you have $800 in depreciation expenses $800 in accumulated depreciation and a closing book value of $7,200 Are you still with me? It gets better I promise We're using the straight-line method which means your depreciation expense is exactly the same for the next nine years So the next nine journal entries are identical to the one we just posted each year you debit the depreciation expense account in your income statement by $800 and credit accumulated depreciation in your balance sheet by $800 and here's the impact on your books At the start of year one you buy an oven so your cash went down by $8,000 and your baking equipment went up by $8,000 this is a balance sheet to balance sheet transaction But during each of the next ten years you post adjusting entries to record a depreciation expense in your income statement of $800 and $800 in accumulated depreciation a contra asset account which offsets the asset cost in your baking equipment account After ten long years the entire cost of your oven has been written off to your income statement So if we net together your baking equipment and accumulated depreciation accounts we can see that the closing book value of your oven has decreased to zero which agrees with your completed depreciation schedule So what's next? Nothing! Well not exactly if you continue to use your oven then it will be fully depreciated but you'll still be carrying it in your books $8,000 in your baking equipment account and $8,000 in accumulated depreciation but combined a net book value of zero When you stop using it you'll need to post one more journal entry Assuming no gain or loss on disposal you'll debit accumulated depreciation by $8,000 and credit baking equipment by $8,000 This journal clears out all of the older entries in your baking equipment and accumulated depreciation accounts leaving you with a balance of zero in each account But sometimes you might sell your oven and make a gain or loss on disposal What would happen then? If you'd like me to cover that then please let me know down below in the comments don't forget to subscribe for more accounting tutorials you can find links to my depreciation playlist and depreciation cheat sheet somewhere on this screen See you soon!

Channel: Accounting Stuff

Views: 161,510

Keywords: depreciation, depreciation accounting, depreciation expense, accumulated depreciation, journal entries, straight line depreciation, depreciation basics, accounting, accounting basics, accounting stuff, capitalization, adjusting entries, depreciation journal entry, depreciation straight line method, how to depreciate, depreciate, adjusting entries depreciation, journal entry, financial accounting, accounting 101

Id: _pas1ETbrj8

Length: 11min 23sec (683 seconds)

Published: Mon May 25 2020