Depreciation Expense
When a company buys an asset that will probably last for greater than one year, the cost of that asset is not counted as an immediate expense. Rather, the cost is spread out over several years in a process known as depreciation.
Straight-Line Depreciation
The most basic form of depreciation is known as straight-line depreciation. Using this method, the cost of the asset is spread out equally over the expected life of the asset.
Example: Daniel spends $5,000 on a new piece of equipment for his carpentry business. He expects the equipment to last for 5 years, by which point it will likely be of no substantial value. Each year, $1,000 of the equipment’s cost will be counted as an expense.
When Daniel first purchases the equipment, he would make the following journal entry:
DR. Equipment 5,000
CR. Cash 5,000
Then, each year, Daniel would make the following entry to record Depreciation Expense for the equipment:
Depreciation Expense 1,000
Accumulated Depreciation 1,000
Accumulated Depreciation is what’s known as a “contra account,” or more specifically, a “contra-asset account.” Contra accounts are used to offset other accounts. In this case, Accumulated Depreciation is used to offset Equipment.
At any given point, the net of the debit balance in Equipment, and the credit balance in Accumulated Depreciation gives us the net Equipment balance—sometimes referred to as “net book value.” In the example above, after the first year of depreciation expense, we would say that Equipment has a net book value of 4,000. (5,000 original cost, minus 1,000 Accumulated Depreciation.)
We make the credit entries to Accumulated Depreciation rather than directly to Equipment so that we:
1. Have a record of how much the asset originally cost, and
2. Have a record of how much depreciation has been charged against the asset already.
Example (continued): Eventually, after 5 years, Accumulated Depreciation will have a credit balance of 5,000 (the original cost of the asset). At this point—once the asset has zero net book value—Daniel will make the following entry to “write off” the asset:
Accumulated Depreciation 5,000
Equipment 5,000
After making this entry, there will no longer be any balance in Equipment or Accumulated Depreciation.