DEPRECIATION BASICS! With Journal Entries - YouTube

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!