When a company buys an asset that will probably last for more than a year, the cost of that asset is not counted as an immediate expense. Rather, the cost is spread out over several years through a process known as depreciation.
The most basic form of depreciation is known as straight-line depreciation. Using this method, the cost of the asset is spread out evenly 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
Then, each year, Daniel would make the following entry to record Depreciation Expense for the equipment:
Dr. Depreciation Expense 1,000
Cr. 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.”
What if a business plans to use an asset for a few years, and then sell it before it becomes entirely worthless? In these cases, we use what is called “salvage value.” Salvage value (sometimes referred to as residual value) is the value that the asset is expected to have after the planned number of years of use.
EXAMPLE: Lydia spends $11,000 on office furniture, which she plans to use for the next ten years, after which she believes it will have a value of approximately $2,000. The furniture’s original cost, minus its expected salvage value is known as its depreciable cost—in this case, $9,000.
Each year, Lydia will record $900 of depreciation as follows:
Dr. Depreciation Expense 900
Cr. Accumulated Depreciation 900
After ten years, Accumulated Depreciation will have a $9,000 credit balance. If, at that point, Lydia does in fact sell the furniture for $2,000, she’ll need to record the inflow of cash, and write off the Office Furniture and Accumulated Depreciation balances:
Dr. Cash 2,000
Dr. Accumulated Depreciation 9,000
Cr.Office Furniture 11,000
Gain or Loss on Sale
Of course, it’s pretty unlikely that somebody can predict exactly what an asset’s salvage value will be several years from the date she bought the asset. When an asset is sold, if the amount of cash received is greater than the asset’s net book value, a gain must be recorded on the sale. (Gains work like revenue in that they have credit balances, and increase owners’ equity.) If, however, the asset is sold for less than its net book value, a loss must be recorded. (Losses work like expenses: They have debit balances, and they decrease owners’ equity.)
Determining whether to make a gain entry or a loss entry is never too difficult:
Just figure out whether an additional debit or credit is needed to make the journal entry balance.
EXAMPLE (CONTINUED): If, after ten years, Lydia had sold the furniture for $3,000 rather than $2,000, she would record the transaction as follows:
Dr. Cash 3,000
Dr. Accumulated Depreciation 9,000
Cr. Office Furniture 11,000
Cr. Gain on Sale of Furniture 1,000