One of the students taking my Real Life Accounting for Non-Accountants online accounting course e-mailed me with a question about “Accumulated Depreciation”. He was having a real hard time comprehending why that account existed. To me, it was clear as a bell. To him, he simply could not see it. I tried explaining it from several different angles and after many e-mails it started to dawn on him. Perhaps there are more people like him who haven’t yet grasped the full concept of depreciation. So let’s discuss how depreciation is journalized. You can review how to understand the process of depreciation using the “straight-line and double-declining methods” in my latest article, “Understanding Depreciation – It’s not as hard as you might think”.
In the article, I explain how a portion of the cost of a fixed asset is allocated to the Depreciation Expense general ledger account each accounting period. The method of doing that requires a debit entry to Depreciation Expense because that general ledger account is being increased (therefore a debit entry) by the allocated cost of the fixed asset. As you know, the rule of double-entry accounting is that the debit entries must equal the credit entries when all is said and done. This means a credit entry must be made for the amount equal to the Depreciation Expense entry.
The credit entry is recorded in an account called “Accumulated Depreciation”. This account is located in the Asset section of the Balance Sheet under Fixed Assets. It can be one account that contains all the accumulated depreciation for various categories of fixed assets such as, Office Equipment, Furniture & Fixtures, Machinery & Equipment, Vehicles, Leasehold Improvements, etc. Or, it can be set up as a separate account located below the fixed asset account it relates to. For example:
Furniture & Fixtures
Accumulated Depreciation – Furniture & Fixtures
It doesn’t matter as it’s up to you.
The main concept to understand here is that the Accumulated Depreciation account is an offset to the Fixed Asset accounts. You could call it a “contra” account. Remember that even though the Accumulated Depreciation account is located in the Asset section it maintains a credit balance. Fixed Assets when purchased are posted as a debit balance because an increase is being recorded. When a portion of the fixed asset is removed and recorded in the Depreciation Expense account then that decrease is recorded in the Accumulated Depreciation account as a credit. This makes sense because the Accumulated Depreciation account’s purpose is to reflect how much of the fixed assets that have been expensed.
Looking at it a different way, we could have simply recorded a credit to the fixed asset account directly. So instead of seeing a fixed asset balance of $500 we might see $450. The problem with this method is that it would be difficult to know at a glance how much we purchased the fixed assets for originally and how much depreciation we have expensed. Using an Accumulated Depreciation account provides us with more information.
Let me know if you have any questions about how this works.
John
7 Comments
A question regarding the Accumulated Depreciation account and the trial balance and post trail balance worksheet. I understand depreciation, how to calculate it and determining the book valve of an asset. My problem is journalizing, updating the general ledger and closing the year out. As depreciation accumulates it has a credit balance but there is no debit entry that will make both debit & credit columns equal. In other words, my equipment was purchased for $1,000 which has a debit balance and remians the same value until the asset is no longer used for business purpose. My accumulated depreciation so far is $400 which has a credit balance. Working my closing worksheet, the trail balance will not equal out in the debit and credit columns because of the Accumulated Depreciation balance. As I make my adjusting entries and continue to the post trail balance the debit and credit columns don’t equal out. It’s off by the amount of the accumulated depreciation balance. So am I missing something here?
Tom: Here is how it works. You purchased equipment for $1000 and recorded a debit (increase) to the fixed asset account Equipment and recorded a credit (decrease) to Cash. Next, you recorded depreciation by debiting (increasing) Depreciation Expense for $400 (over time) and crediting (increasing) Accumulated Depreciation by $400. Can you see that the debits equal the credits? The debit you are looking for is the debit of $400 to Depreciation Expense. At the end of the year all income and expenses (including depreciation expense) get closed out into the equity account on the balance sheet. Equipment and cash cancel each other out for $1000. Depreciation expense (now located in the equity section) and Accumulated Depreciation cancel each other out for $400. When you run your trial balance your debits should equal your credits. Have you closed your income and expense statement into equity yet? Even if you haven’t done that yet your debits should equal your credits. I’m not sure what you are doing or have done, but the above is how it is supposed to work.
Hi,
Love the site. I have a question regarding the depreciation of prepayments. How do I account for the depreciation of prepayments on a software package. It is a semi-custom piece of software that we had to pay for partially up front. This up front payment was for the customizations that were necessary.
Thank you!
John: You can’t depreciate the software until it is placed in service. Therefore, post your prepayments into Misc Suspense until you actually receive and place in service the software. For example, if the total software cost $1,000 you would debit fixed assets Equipment for $1,000, and if your prepayments were $400, you would credit Suspense by $400 and if you still owed on the item you would credit $600 to Accounts Payable. Check out my article on Miscellaneous Suspense on my website.
Hope this helps.
John: Thank you for the information regarding depreciation. I found the mistake back in my first year books (2009) and corrected it there. I also corrected in my 2010 books now I’m good to go. I also found another mistake on handling the Petty Cash account and I was able to resolve it as well. Thanks again.
A company had a piece of equipment stolen and received a insurance cheque. How does it get recorded.
F. Stefano: Treat it just like you would a sale of equipment. Read my article on Disposing of Assets at http://www.reallifeaccounting.com/pubs/Article_Theme_Disposing_of_Assets.pdf. Substitute the sales price for the amount received from the insurance company. The article explains how to determine the gain or loss on the disposition of the asset. Then write your journal entry which would look like this:
Debit Cash (Insurance check); Debit Accumulated Depreciation; Credit Equipment (original cost); and then debit loss on disposition or credit gain on disposition depending which way it goes.
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