DEPRECIATION

The Concept of Depreciation

Depreciable assets are physical objects that retain their size or shape but that eventually wear out
or become obsolete. They are not physically consumed as are assets such as supplies, but
nonetheless their economic usefulness diminishes over time.

Examples of depreciation assets include buildings and all types of equipment, fixtures,
furnishings etc. Land, however, is not viewed as a depreciable asset as it has an unlimited useful
life.

Each period, a portion of a depreciable asset’s usefulness expires. Therefore, a corresponding

portion of its cost is recognized as depreciation expense.

What is Depreciation?
From an accounting point of view:

A system which aims to distribute the cost or other basic value of tangible capital assets (less
salvage, if any) over the estimated useful life of the plant/unit. It is considered a process of
allocation –not of valuation. It is the “Systematic allocation of the cost of a depreciable asset to
expense over the asset’s useful life”. This process is stated below:

Figure: Depreciation process of allocating the cost of a depreciable asset to

expense.

1
Depreciation expense occurs continuously over the life of the asset but there are no daily
“Depreciation Transactions”. In effect depreciation expense is paid in advance when the asset is
originally purchased. Therefore, adjusting entries are needed at the end of each accounting
period to transfer an appropriate amount of the asset’s cost to depreciation expense.

Depreciation is Only an Estimate

The appropriate amount of depreciation expense is only an estimate. After all, we cannot look at
a building or a piece of equipment and determine precisely how much of its economic usefulness
has expired during the current period.

Some Basic Terminologies Associated With Depreciation

Service life of an asset (equipment)

The useful period during which an asset or property is economically feasible to use. The U.S
Bureau of Internal Revenue recognizes the importance of depreciation as a legitimate expense
for industrial organization. It is for this reason that the Bureau publishes an official listing of
estimated services lives of many assets. (See Table 1)

Salvage Value/ Junk (Scrap) Value

The value of the asset by the end of its useful life service. The term “Salvage” would imply that
the asset can be use, and is worth more merely its scrap or junk value. The latter definition is
applicable to cases where assets are dismantled and have to be sold as junk.

The estimation of these Values-Including the life time-is generally based on the conditions of the
asset when installed. In many cases, zero values are designated to the salvage and junk values.

Book value, present asset value or unamortized cost

The value of an asset or equipment as it appears in the official accounting records (book) of an
organization. It is equal to the original cost minus all depreciation cost made to date.

Market Value
The value obtained by selling an asset in the market. In some conditions, if equipment is properly
maintained, its market value could be higher than the book value.

2
Replacement Value
As the name implies, it is the cost required to replace an existing asset, when needed, with one
that will function in a satisfactory manner.

Depletion
It is defined as the capacity loss due to materials consumed or produced.

Depletion from an accounting point of view are costs that are made to account or compensate for
the loss in the value of the mineral or oil property because of the exhaustion of the natural
resources.

Table 1 : Estimated Service Life of Assets

Life (years)
Group I: General business assets
1. Office furniture, fixtures, machines, equipment 10
2. Transportation
a. Aircraft 6
b. Automobile 3
c. Buses 9
d. General-purpose trucks 4-6
e. Railroad cars (except for railroad companies) 15
f. Tractor units 4
g. Trailers 6
h. Water transportation equipment 18
3. Land and site improvements (not otherwise covered) 20
4. Buildings (apartments, banks, factories, hotels, stores, warehouses) 40-60
Group II: Non-manufacturing activities (excluding transportation,
Communications and public utilities)
1. Agriculture
a. Machinery and equipment 10
b. Animals 3-10
c. Trees and vines variable
d. Farm buildings 25
2. Contract construction
a. General 5
b. Marine 12
3. Fishing variable
4. Logging and sawmilling 6-10
5. Mining (excluding petroleum refining and smelting
and refining of minerals) 10
6. Recreation and amusement 10
7. Services to general public 10
8. Wholesale and retail trade 10

3
Group III: Manufacturing
1. Aerospace industry 8
2. Apparel and textile products 9
3. Cement (excluding concrete products) 20
4. Chemicals and allied products 11
5. Electrical equipment
a. Electrical equipment in general 12
b. Electronic equipment 8
6. Fabricated metal products 12
7. Good products, except grains, sugar and vegetable oil products 12
8. Glass products 14
9. Grain and grain-mill products 17
10. Knitwear and knit products 9
11. Leather products 11
12. Lumber, wood products and furniture 10
13. Machinery not otherwise listed 12
14. Metalworking machinery 12
15. Motor vehicles and parts 12
16. Paper and allied products
a. Pulp and paper 16
b. Paper conversion 12
17. Petroleum and natural gas
a. Contract drilling and field service 6
b. Company exploration, drilling and production 14
c. Petroleum refining 16
d. Marketing 16
18. Plastic products 11
19. Primary metals
a. Ferrous metals 18
b. Nonferrous metals 14
20. Printing and publishing 11
21. Scientific instruments, optical and clock manufacturing 12
22. Railroad transportation equipment 12
23. Rubber products 14
24. Ship and boat building 12
25. Stone and clay products 15
26. Sugar products 18
27. Textile mill products 12-14
28. Tobacco products 15
29. Vegetable oil products 18
30. Other manufacturing in general 12
Group IV: Transportation, communication and public utilities
1. Air transport 6
2 Central steam production and distribution 28
3. Electric utilities
a. Hydraulic 50

4
 b. Nuclear 20
c. Steam 28
d. Transmission and distribution 30
4. Gas utilities
a. Distribution 35
b. Manufacture 30
c. Natural-gas production 14
d. Trunk pipelines and storage 22
5. Motor transport (freight) 8
6. Motor transport (passengers) 8
7. Pipeline transportation 22
8. Radio and television broadcasting 6
9. Railroads
a. Machinery and equipment 14
b. Structures and similar improvements 30
c. Grading and other right of way improvements variable
d. Wharves and docks 20
10. Telephone and telegraph communications variable
11. Water transportation 20
12. Water utilities 50
Source: U.S Bureau of Internal Revenue

Methods for Determining Depreciation

Companies employ several different depreciation methods. Generally accepted accounting
principles require only that a depreciation method result in a rational systematic allocation of
cost over the asset’s useful life.

The most widely used means of estimating periodic depreciation expense is the straight-line
method of depreciation. Under this approach an equal portion of the asset’s cost is allocated to
depreciation expense in every period of the asset’s estimated useful life.

The formula for computing depreciation expense by the straight line method is:

The use of an estimated useful life is the major reason that depreciation expense is only an
estimate. In most cases, management does not know in advance exactly how long the asset will
remain in use.

In their financial statements, most companies determine depreciation expense by the straight line
method.

Most of the other depreciation methods are various forms of accelerated depreciation. The term
accelerated depreciation means that larger amounts of depreciation are recognized in the early

5
years of the asset’s life and smaller amounts are recognized in the later years. Over the entire life
of the asset, however, both the straight line method and accelerated methods recognize the same
total amount of depreciation.

Different depreciation methods may be used for different assets, of course, the depreciation
methods in use should be disclosed in notes accompanying the financial statements.

Illustration by Example of Straight Line Method

On Jan 2, a construction based company acquires a new Truck. The data and estimated needed
for the computation of the annual depreciation expense are given below:

Cost…………………………… $17,000
Estimated Residual Value……. $2,000
Estimated Useful Life…………..5 years

Using the above data, the annual straight-line depreciation is computed as follows:

This same depreciation computation is shown in tabular form as follows:

Cost of the depreciable cost…………………………………………..$ 17,000

Less: Estimated residual value (amount to be realized by sale of asset when it is

retired from use)…………………………………………...................$2,000_

Total amount to be depreciated (Depreciable cost)…………………$15,000

Estimated Useful Life…………………………………………………5 years

Depreciation expense each year ($15,000/5)………………………...$ 3,000

6
The following depreciation schedule summarizes the effects of straight-line depreciation over the
entire life of the asset.

Depreciation Schedule: Straight Line Method

Accumulated
Year Computation Depreciation Expense Depreciation Book Value
First $15,000 1/5 $3,000 3,000 14,000
Second $15,000 1/5 $3,000 6,000 11,000
Third $15,000 1/5 $3,000 9,000 8,000
Fourth $15,000 1/5 $3,000 12,000 5,000
Fifth $15,000 1/5 $3,000 15,000 2,000
Total $15,000

It is often convenient to state the portion of an asset’s depreciable cost that will be written off
during the year as a percentage called the depreciation rate. When straight line depreciation is in
use, the depreciation rate is simply divided by the life (in years) of the asset. The delivery truck
in above example has an estimated life of 5 years, so the depreciation expense each year is 1/5
or 20% of the depreciable amount. Similarly an asset with a 10-year life has a depreciation rate
of 1/10 or 10% and an asset with an 8 year life has a depreciation rate of 1/8 or 12.5%.

The Same Example from an Algebraic point of view

If V=Value of asset

& t=time in years

Then Book value of the asset can be expressed as:

V=17000-3000t

When t=1, V1=17000-3000=14000

& when t=2, V2=17000-6000=11000

& so on.

When t=5 (end of useful life)

V=17000-15000

V=2000 (scrap value)

7
See figure

V
17000

2000

1 2 3 4 5 t

The Declining-Balance Method

By far the most widely used accelerated depreciation is called fixed-percentage-of-declining-
balance depreciation. However, the method is used primarily in income tax returns, rather than
financial statements.

Under the declining-balance method, an accelerated depreciation rate is computed as a specified

percentage of the straight-line depreciation rate. Annual depreciation expense then is computed
by applying this accelerated depreciation rate to the undepreciated cost (current book value) of
the asset. This computation may be summarized as follows:

The accelerated depreciation rate remains constant throughout the life of the asset. Hence, the
rate represents the “fixed-percentage” described in the name of this depreciation method. The
book value (cost minus accumulated depreciation) decreases every year and represents the
“declining-balance”.

The declining balance method assumes that the equipment in question will contribute more to the
earning of revenues in the early stage of useful life than it will as the equipment gets older.

A valid use of a declining pattern of depreciation occurs when it is felt that obsolescence will
exert a strong influence on the life of the equipment but there is no way of predicting when it
will occur.

8
Thus far, we have described the accelerated depreciation rate as a “specified percentage” of the
straight-line rate. Most often, this specified percentage is 200%, meaning that the accelerated rate
is exactly twice the straight-line rate. As a result, the declining-balance method of depreciation
often is called double-declining-balance (or 200%-declining-balance). Tax rules, however, often
specify a lower percentage, such as 150% of the straight-line rate. This version of the declining-
balance method may be described as “150%-declining-balance”.

Double-Declining-Balance: To illustrate the double-declining-balance method, consider

our example of the $17,000 delivery truck. The estimated useful life is 5 years; therefore, the

straight-line depreciation rate is 20% ( years). Doubling this straight-line rate indicates an
accelerated depreciation rate of 40%. Each year, we will recognize as depreciation expense 40%
of the truck’s current book value, as follows:

Depreciation Schedule: 200% Declining-Balance Method

Depreciation Accumulated Book
Year Computation Expense Depreciation Value
$17,000
First……………………… $17,000 40% $6,800 $ 6,800 10,200
Second…………………… $10,200 40% 4,080 10,880 6,120
Third…………………….. $ 6,120 40% 2,448 13,328 3,672
Fourth………………........ $ 3,672 40% 1,469 14,797 2,203
Fifth…………………….. $ 2,203 40% 203 15,000 2,000
Total……………….. $15,000

Notice that the estimated residual value of the delivery truck does not enter into the computation
of depreciation expense until the very end. This is because the declining-balance method
provides an “automatic” residual value. As long as each year’s depreciation expense is equal to
only a portion of the undepreciated cost of the asset, the asset will never be entirely written off.
However, if the asset has a significant residual value, depreciation should stop at this point.
Since our delivery truck has an estimated residual value of $2,000, the depreciation expense for
the fifth year should be limited to $203, rather than the $881 indicated by taking 40% of the
remaining book value. By limiting the last year’s depreciation expense in this manner, the book
value of the truck at the end of the fifth year will be equal to its $2,000 estimated residual value.

In the schedule illustrated on the previous page, we computed a full year’s depreciation in the
first year because the asset was acquired on January 2. But if the half-year convention were in

9
use, depreciation in the first year would be reduced by half, to $3,400. The depreciation in the
second year would be ($17,000 - $ 3,000) 40%, or $5,440.

150%-Declining-Balance now assume that we wanted to depreciate this truck using 150%
of the straight-line rate. In this case, the depreciation rate will be 30%, instead of 40% (a 20%

straight-line rate 150% = 30%) the depreciation schedule appears as follows:

Depreciation Schedule: 150% Declining-Balance Method

Depreciation Accumulated Book
Year Computation Expense Depreciation Value
$17,000
First……………… $17,000 30% $5,100 $ 5,100 11,900
Second…………… $11,900 30% 3,570 8,670 8,330
Third………………$ 8,330 30% 2,499 11,169 5,831
Fourth……………..$ ($5,831 - $2,000) 2 1,916* 13,085 3,915
Fifth……………….$ $3,915 - $2,000 1,915* 15,000 2,000
Total……………….. $15,000
*Switched to the straight-line method for years 4 and 5.

Notice that we switched to straight-line depreciation in the last 2 years. The undepreciated cost
of the truck at the end of year 3 was $3,831 in depreciation expense must be recognized over the
next 2 years. At this point, larger depreciation charges can be recognized over the next 2 years.
At this point, larger depreciation charges than continuing to compute 30% of the remaining book
value. (In our table, we round the allocation of this amount to the nearest dollar.)

Allocating the remaining book value over the remaining life by the straight-line method does not
represent a change in depreciation method. Rather, a switch to straight-line when this will result
in larger depreciation is part of the declining-balance method. This is the way in which we arrive
at the desired residual value.

MACRS: The Tax Method

In 1986, Congress adopted the Modified Accelerated Cost Recovery System, called MACRS
(pronounced “makers”). Companies may use straight-line depreciation for income tax purposes,
but most prefer to use an accelerated method. MACRS is the only accelerated depreciation
method that may be used in federal income tax returns (for assets placed in service after 1986)

Under MACRS, all plant assets are assigned one of nine recovery periods: 3, 5, 7, 10, 15, 20,
, or 39 years. For example, some special-purpose manufacturing tools are classified as

10
“3-year property,” meaning that they are depreciated over a 3-year life. Automobiles, light-
trucks, and computers are “5-year property.” Any depreciable asset that is not assigned a specific
class life is treated as “7-year property.”

MACRS depreciation is based on the fixed-percentage-of-declining-balance method, with one

modification-there is no provision for residual value. Thus 100% of the asset’s cost is allocated
to expense over the specific recovery period. Assets with recovery periods of 10 years or less are
depreciated by the 200%-declining-balance method; assets with recovery periods of 15 or 20
years are depreciated by the 150%-declining-balance method. The half-year convention normally
is applied in all recovery periods of 20 years or less.

Actually, taxpayers need not compute MACRS depreciation using the declining-balance
methods. The Internal Revenue Service publishes depreciation rate tables that show the
percentage of cost that may be deducted in each year of the recovery period. These tables
automatically apply the half-year convention and switch to straight-line in the appropriate year to
maximize the taxpayer’s deduction for depreciation.

11
A MACRS depreciation rate table for all recovery periods up to 20 years appears below

MACRS Depreciation Rates*

Recovery Period
Year 3 Years 5 Years 7 Year 10 Year 15 Year 20 Year
1 33.33% 20.00% 14.29% 10.00% 5.00% 3.75%
2 44.45% 32 24.49 18 9.5 7.219
3 14.81 19.2 17.49 14.4 8.55 6.677
4 7.41 11.52 12.49 11.52 7.7 6.177
5 11.52 8.93 9.22 6.93 5.713
6 5.76 8.92 7.37 6.23 5.285
7 8.93 6.55 5.9 4.888
8 4.46 6.55 5.9 4.522
9 6.56 5.91 4.462
10 6.55 5.9 4.461
11 3.28 5.91 4.462
12 5.9 4.461
13 5.91 4.462
14 5.9 4.461
15 5.91 4.462
16 2.95 4.461
17 4.462
18 4.461
19 4.462
20 4.461
21 2.231
Total 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Caution: This table is intended for demonstration purposes only. Congress may change the depreciation rat es
permitted for income tax purposes at any time. Therefore, this table should not be used in the preparation of actual
income tax returns. Complete and up-to-date depreciation tables are available without charge from the Internal
Revenue Service.

The percentage of the asset’s cost that can be deducted in the firsty year is relatively small,
reflecting the half-year convention. After the first year, the percentages start out relatively high
and then decline-the basic characteristic of an accelerated depreciation method. Near the end of
the recovery period, the percentages stop changing. This represents the switch to the straight-line
method in order to de4preciate the asset fully.

Notice that the depreciation rates in each recovery period add up to 100%. This demonstrates that
the MACRS method fully depreciates all assets, with no provision for salvage value.

12
Computing Depreciation for Income tax Purposes: An Illustration
To illustrate the use of the rate table, let us consider our example of S&G Grocery’s delivery
truck, which cost $17,000. (For tax purposes, we will disregard the $ 2,000 residual value.) under
current tax rules, light-duty trucks are considered 5-year property. The depreciation expense that
may be deducted in the federal income tax return each year is determined as follows:

Depreciation Schedule: MACRS Income Tax Method

Computation
(Cost * Rate from IRS Depreciation Accumulated Basis (Book
Year Table) Expense Depreciation Value)
1 $17,000 20% $3,400 $3,400 $13,600
2 $17,000 32% 5,550 8,840 8,160
3 $17,000 19.2% 3,264 12,104 4,896
4 $17,000 11.52% 1,958 14,062 2,938
5 $17,000 11.52% 1,958 16,020 980
6 $17,000 5.76% 980 17,000 0
Total $17,000

Notice that “5-year property” actually is depreciated over 6 years. The extra year results from
application of the half-year convention. Also, notice that in tax schedules the term basis replaces
book value. The concepts of basis And book value are quite similar. Both terms represent the
undepreciated cost of the asset; that is, cost less accumulated depreciation. Book value represents
the cost of the asset less the accumulated depreciation recognized in financial statements. Basis,
in contrast, represents the cost of the asset less the accumulated depreciation claimed in income
tax returns. Stated another way, basis means “book value for tax purposes.”

Which Depreciation Methods Do Most Businesses Use?

Most businesses use the straight-line method of depreciation in their financial statements and
accelerated methods in their income tax returns. The reasons for these choices are easy to
understand.

Accelerated depreciation methods result in higher charges to depreciation expense and, therefore,
lower reported net income than straight-line depreciation. Most publicly owned companies want
to appear as profitable as possible-certainly as profitable as their competitors. Therefore, the
overwhelming majority of publicly owned companies use straight-line depreciation in their
financial statements.

13
For income tax purposes, it’s a different story. Management usually wants to report the lowest
possible taxable income in the company’s income tax returns. Accelerated depreciation methods
can substantially reduce both taxable income and tax payments for a period of years.

Accounting principles and income tax laws both permit companies to use different depreciation
methods in their financial statements and their income tax returns. Therefore, most companies
use straight-line depreciation in their financial statements and accelerated methods (MACRS or
other variations of the declining-balance method) in their income tax returns.

The Differences in Depreciation Methods: Are They “Real”?

Using the straight-line depreciation method will cause a company to report higher profits than
would be reported if an accelerated method were in use. But is the company better off than if it
had used an accelerated method? The answer is no! Depreciation-no matter how it is computed-is
only an estimate. The amount of this estimate has no effect on the actual financial strength of the
business. Thus a business that uses an accelerated depreciation method in its financial statements
is simply measuring its net income more conservatively than a business that uses straight-line.

OTHER DEPRECIATION METHODS

Most companies that prepare financial statements in conformity with generally accepted
accounting principles use the straight-line method of depreciation. However, any rational and
systematic method is acceptable, as long as costs are allocated to expense in a reasonable
manner. Several such methods are discussed here.

The Units-of-Output Method

Under the units-of-output method, depreciation is based on some measure of output other than
the passage of time. When depreciation is based on units of output, more depreciation is
recognized in the periods in which the assets are most heavily used.

To illustrate this method, consider S&G’s delivery truck, which caused $17,000 and has an
estimated salvage value of $2,000. Assume that S&G plans to retire this truck after it has been
driven 100,000 miles. The depreciation rate per mile of operation amounts to 15 cents, computed
as follows:

14
At the end of each year, the amount of depreciation to be recorded would be determined by
multiplying the 15-cents rate by the number of miles the truck had been driven during the year.
After the truck has gone 100,000 miles, it is fully depreciated, and the depreciation program is
stopped.

This method provides an excellent matching of expense with revenue. However, the method
should be used only when the total units of output can be estimated with reasonable accuracy.
Also, this method is used only for assets such as vehicles and certain types of machinery. Assets
such as buildings, computers, and furniture do not have well-defined “units of output.”

In many cases, Units-of-output is an accelerated method. Often assets are used more extensively
in the earlier years of their useful lives than in the later years.

MACRS
We have explained that most businesses use MACRS in their federal income tax returns. Some
small businesses also used this method in their financial statements, so they do not have to
compute depreciation in several different ways. MACRS is based on the declining-balance
method, which, in itself, is acceptable for use in financial statements.

MACRS should be used in financial statements only if the designated “recovery periods”

And the assumption of no salvage value are reasonable. Otherwise, MACRS will fail to properly
match depreciation expense with revenue over the asset’s estimated useful life.

Sum-of-the-Years’ Digits
Sum-of-the-years’ digits, or SYD, is a form of accelerated depreciation. It generally produces
results that lie between the double-declining- balance and 150%-declining-balance methods.

SYD is something of a “traditional” topic in accounting textbooks. But it is the most complex of
the accelerated methods--- especially when partial; years are involved. And SYD is rarely used
in today’s business world. As shown in the table on the following page, only 11 of the 600
corporations surveyed---less than 2%--make any use of this method. Because of its complexity, it
is even less frequently used in small businesses. SYD is seldom used for income tax purposes,
because tax laws usually define allowable depreciation rates in terms of the declining-balance
method. For these reasons, we will defer coverage of the mechanics of this method to later
accounting courses.

Decelerated Depreciation Methods

Depreciation methods do exist that recognize less depreciation expense in the early years of an
asset’s useful life and more in the later years. Such methods may achieve a reasonable matching

15
of depreciation expense and revenue when the plant asset is expected to become increasingly
productive over time. Utility companies, for example, may use these methods for new power
plants that will be more fully utilized as the population of the area increases.

These depreciation methods are rarely used; thus we will again defer coverage to later
accounting courses.

COMPARISON BETWEEN THE DEPRECIATION METHODS

The choice of the best depreciation is not a straightforward task. It is not our purpose to explore
here the details of depreciation accounting methods. Suffice it to say that the following factors
are important in choosing one method of depreciation and not the other:

1. Type and function of property: lifetime, salvage value

2. Time value of money (interest)
3. Simplicity
4. Choose the one for which the present worth of all depreciation charges is a maximum.

In the absence of guidelines and for quick results, the following rules are recommended:

1. Use straight-line depreciation (simple)

2. Take the useful lifetime of the asset = 10 years
3. Assume salvage value = zero

16
Now, we can make the following specific comparison:

Straight-line and sinking fund versus Declining balance and sum of digits

 Annual depreciations costs are  Annual depreciation costs are

constant. changing, greater in early life than in
later years.
 Asset value is higher for (S.F.D)  Used for equipment where the greater
because of the effect of I, as compared proportion of production occurs in the
to (S.L.D). early part of life, or when operating
costs increase with age.
 S.L.D is simple and widely used.  Both methods are classified as
“accelerated depreciation” type. They
provide higher financial protection.
 S.F.D. is seldom used. It is applicable  For D.D.B.D., the annual fixed
for assets that are sound in percentage factor is constant, while for
performance and stand little chance of S.D.D. it is changing.
becoming obsolete.

17
Recording Depreciation Expense: An Illustration
Overnight Auto Service owns two categories of depreciable assets: its building, and its tools and
equipment. Because these categories of assets have different useful lives, depreciation must be
computed separately for each category. Overnight elects to compute depreciation expense by
the straight-line method.

Depreciation on the Building Overnight purchased its building for $30,000. Because
the building was old, McBryan estimates that it has a remaining useful life of only 20 years.
Thus Overnight will recognize annual depreciation expense equal to 1/20 of the building’s cost,
or $1,800 ($36,000 cost 20-year estimated useful life). On a monthly basis, the depreciation
expense amounts to $150 ($36,000 cost 240 months).

The adjusting entry to record depreciation on this building for the month of December appears below:

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec. 31, 2001 Depreciation Expense: Building………………… 150

Accumulated Depreciation: Building………… 150

To record on month’s depreciation on building

(cost, $36,000, divided by estimated useful life,
240 months, equals $150 per month).

The Depreciation Expense account will appear in Overnight’s income statement for December, along
with the other expenses for the month. The Accumulated Depreciation account will appear in the
balance sheet as a deduction from the balance of the Building account, as shown below:

18
 OVERNIGHT AUTO SERVICE

Partial Balance Sheet

December 31, 2001

Assets

Cash………………………………………………………………………………………$14,220

Accounts Receivable…………………………………………………………………… 6,600

Shop Supplies…………………………………………………………………………… 1,000

Land……………………………………………………………………………………… 52,000

Building……………………………………………………………………….. $36,000

Less: Accumulated Depreciation…………………………………………… 150 35,850

The end result of crediting the Accumulated Depreciation: Building account is much the same as if the
credit had been made to the Building account; that is, the net amount shown on the balance sheet for
the building is reduced from $36,000 to $35,850. Although the credit side of a depreciation entry could
be made directly to the asset account, it is customary and more efficient to record such credits in a
separate account entitled Accumulated Depreciation. The original cost of the asset and the total amount
of depreciation recorded over the years can more easily be determined from the ledger when separate
accounts are maintained for the asset and for the accumulated depreciation.

Accumulated Depreciation: Building is an example of a contra-asset account, because it has a credit

balance and is offset against an asset account (Building) to produce the proper balance sheet amount
for the asset.

Depreciation on the Tools and Equipment Overnight also must record depreciation
on its tools and equipment. These assets cost $12,000, and management estimates that they will
remain in service for about five years. Thus the monthly depreciation expense amounts to $200
($12,000 cost 60 months). The adjusting entry to recognize this monthly expense is:

19
 GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec. 31, 2001 Depreciation Expense: Tools and Equipment…… 200

Accumulated Depreciation: Tools and

E Equipment……………………………………..
200

To record depreciation on tools and equipment

($12,000/60 months).

Similar adjusting entries to recognize depreciation expense on the building and tools and equipment will
be made each month throughout the assets’ useful lives. Depreciation begins when the assets are
placed in use for the intended business purpose. Once the assets have become fully depreciated, that is,
their total cost has been recognized as depreciation expense, the recognition of depreciation will stop.
(We did not recognize depreciation on these assets in November, because Overnight operated for only
part of the month.)

The Adjusted Trial Balance

After all the necessary adjusting entries have been journalized and posted, an adjusted trial balance is
prepared to prove that the ledger is still in balance. It also provides a complete listing of the account
balances to be used in preparing the financial statements. The following adjusted trial balance differs
from the trial balance shown on page 106 because it includes several new account titles, and the
balances in some existing accounts have been adjusted.

Once an adjusted trial balance has been prepared, the process of recording changes in financial
position for this accounting period is complete. Financial statements are prepared directly from the
adjusted trial balance.

Every account in the adjusted trial balance contains its end-of-the-period balance, with the exception
of the owner’s capital account. During the accounting period, many transactions affecting owner’s
equity were not recorded directly in the owner’s capital account. Rather, these transactions were
recortded in the various revenue and expense accounts or in the owner’s drawing account. Therefore,
the balance in the owner’s capital account shown in the adjusted trial balance is not completely up to
date. This will not cause a problem; as we prepare financial statements, the amount of the owner’s
equity at the end of the period will become apparent.

20
 OVERNIGHT AUTO SERVICE

Adjusted Trial Balance

December 31, 2001

Cash…………………………………………………………………………. $14,220

Accounts Receivable……………………………………………………….. 6,600

Shop Supplies………………………………………………………………. 1,000

Land…………………………………………………………...……………... 52,000

Building……………………………………………………………………….. 36,000

Accumulated Depreciation: Building………………………………………. 150

Tools and Equipment………………………………………………………… 12,000

Accumulated Depreciation: Tools and Equipment……………………….. 200

Notes Payable………………………………………………………………… 30,000

Accounts Payable……………………………………………………………. 8,870

Michael McBryan, Capital………………………………………………….... 81,800

Michael McBryan, Drawing………………………………………………….. 3,100

Repair Service Revenue…………………………………………………….. 10,380

Advertising Expense………………………………………………………….. 830

Wage Expense………………………………………………………………… 4,900

Supplies Expense…………………………………………………………….. 400

Depreciation Expense: Building……………………………………………... 150

Depreciation Expense: Tools and Equipment……………………………… 200 _________

131,400 131,400

21
22