Adjusting Entry for Depreciation Expense

When a fixed asset is acquired by a company, it is recorded at cost (generally, cost is

equal to the purchase price of the asset). This cost is recognized as an asset
and not expense.
The cost is to be allocated as expense to the periods in which the asset is used. This is
done by recording depreciation expense.
There are two types of depreciation – physical and functional depreciation.
Physical depreciation results from wear and tear due to frequent use and/or exposure to
elements like rain, sun and wind.
Functional or economic depreciation happens when an asset becomes inadequate for its
purpose or becomes obsolete. In this case, the asset decreases in value even without any
physical deterioration.

Understanding the Concept of Depreciation

There are several methods in depreciating fixed assets. The most common and simplest is

The straight-line depreciation method.

Under the straight line method, the cost of the fixed asset is distributed evenly over the
life of the asset.
For example, ABC Company acquired a delivery van for $40,000 at the beginning of 2012.
Assume that the van can be used for 5 years. The entire amount of $40,000 shall be
distributed over five years, hence a depreciation expense of $8,000 each year.

Straight-line depreciation expense is computed using this formula:

Depreciable Cost – Residual Value
Estimated Useful Life
Depreciable Cost: Historical or un-depreciated cost of the fixed asset
Residual Value or Scrap Value: Estimated value of the fixed asset at the end of its
useful life
Useful Life: Amount of time the fixed asset can be used (in months or years)
In the above example, there is no residual value. Depreciation expense is computed as:
= $40,000 – $0
5 years
= $8,000 / year
With Residual Value
What if the delivery van has an estimated residual value of $10,000? The depreciation
expense then would be computed as:
= $40,000 – $10,000
5 years
= $30,000
5 years
= $6,000 / year

Journal Entry for the Fixed Asset:

When a fixed asset is added, the applicable fixed asset account is debited and
accounts payable is credited.

How to Record Depreciation Expense

Depreciation is recorded at expense account by
 This is recorded at the end of the period (usually, at the end of every month, quarter, or
year).
The entry to record the $6,000 depreciation every year would be:
Dec 31 Depreciation A/c -Van 6,000.00

Accumulated Depreciation 6,000.00

Depreciation Expense: An expense account; hence, it is presented in the income

statement. It is measured from period to period. In the illustration above, the depreciation
expense is $6,000 for 2012, $6,000 for 2013, $6,000 for 2014, etc.
Accumulated Depreciation: A balance sheet account that represents the accumulated
balance of depreciation. Accumulated Depreciation is credited
when Depreciation Expense is debited in each accounting period.
It is continually measured; hence the accumulated depreciation balance is $6,000 at the
end of 2012, $12,000 in 2013, $18,000 in 2014, $24,000 in 2015, and $30,000 in 2016.
Accumulated depreciation is a contra-asset account. It is presented in the balance sheet as
a deduction to the related fixed asset. Here's a table illustrating the computation of the
carrying value of the delivery van.
2012 2013 2014 2015 2016

Delivery Van - Historical Cost $40,000 $40,000 $40,000 $40,000 $40,000

Less: Accumulated Depreciation 6,000 12,000 18,000 24,000 30,000

Delivery Van - Carrying Value $34,000 $28,000 $22,000 $16,000 $10,000

Notice that at the end of the useful life of the asset, the carrying value is equal to the
residual value.
Depreciation for Acquisitions Made Within the Period
The delivery van in the example above has been acquired at the beginning of 2012, i.e.
January. Therefore, it is easy to calculate for the annual straight-line depreciation. But
what if the delivery van was acquired on April 1, 2012?
In this case we cannot apply the entire annual depreciation in the year 2012 because the
van has been used only for 9 months (April to December). We need to prorate.
For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500.
Years 2013 to 2016 will have $6,000 annual depreciation expense.
In 2017, the van will be used for 3 months only (January to March) since it has a useful
life of 5 years (i.e. April 1, 2012 to March 31, 2017).
The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus
completing the accumulated depreciation of $30,000.

2012 (April to December) $ 4,500

2013 (entire year) 6,000

2014 (entire year) 6,000

2015 (entire year) 6,000

2016 (entire year) 6,000

2017 (January to March) 1,500

Total for 5 years $ 30,000

How to write off a fixed asset

A fixed asset is written off when if the asset is sold off or otherwise disposed
of. A write off involves removing all traces of the fixed asset from the balance
sheet, so that the related fixed asset account and accumulated depreciation
account are reduced.

There are two scenarios under which a fixed asset may be written off. The first
situation arises when you are eliminating a fixed asset without receiving any
payment in return. This is a common situation when a fixed asset is being
scrapped because it is obsolete or no longer in use, and there is no resale
market for it. In this case,

Reverse any accumulated depreciation and

Reverse the original asset cost.
If the asset is fully depreciated, that is the extent of the entry.
For example, ABC Corporation buys a machine for $100,000 and recognizes
$10,000 of depreciation per year over the following ten years. At that time,
the machine is not only fully depreciated, but also ready for the scrap heap.
ABC gives away the machine for free and records the following entry.
Debit Credit

Accumulated depreciation 100,000

Machine asset 100,000

A variation on this first situation is to write off a fixed asset that has not yet
been completely depreciated. In this situation, write off the remaining
undepreciated amount of the asset to a loss account. To use the same
example, ABC Corporation gives away the machine after eight years, when it
has not yet depreciated $20,000 of the asset's original $100,000 cost. In this
case, ABC records the following entry:

Debit Credit

Loss on asset disposal 20,000

Accumulated depreciation 80,000

Machine asset 100,000

The second scenario arises when you sell an asset, so that you receive cash (or
some other asset) in exchange for the fixed asset you are selling. Depending
upon the price paid and the remaining amount of depreciation that has not
yet been charged to expense, this can result in either a gain or a loss on sale
of the asset.

For example, ABC Corporation still disposes of its $100,000 machine, but does
so after seven years, and sells it for $35,000 in cash. In this case, it has already
recorded $70,000 of depreciation expense. The entry is:

Debit Credit

Cash 35,000

Accumulated depreciation 70,000

Gain on asset disposal 5,000

Machine asset 100,000

What if ABC Corporation had sold the machine for $25,000 instead of
$35,000? Then there would be a loss of $5,000 on the sale. The entry would
be:

Debit Credit

Cash 25,000

Accumulated depreciation 70,000

Loss on asset disposal 5,000

Machine asset 100,000

A fixed asset write off transaction should only be recorded after written
authorization concerning the targeted asset has been secured. This approval
should come from the manager responsible for the asset, and sometimes also
the chief financial officer.

Fixed asset write offs should be recorded as soon after the disposal of an
asset as possible. Otherwise, the balance sheet will be overburdened with
assets and accumulated depreciation that are no longer relevant. Also, if an
asset is not written off, it is possible that depreciation will continue to be
recognized, even though there is no asset remaining. To ensure a timely write
off, include this step in the monthly closing procedure.

Accounting for Bad Debts

While making sales on credit, the company is well aware that not all of its debtors will pay
in full and the company has to encounter some losses called bad debts. Bad debts
expenses can be recorded using two methods viz. 1.) Direct write-off method and 2.)
Allowance method.
#1 – Direct Write-Off Method
Bad debts are recorded as a direct loss from defaulters, writing off their accounts and
transferred in full amount to P&L account, thus lowers your net profit.
E.g. Mr. Unreal passed away and will not be able to make any payment.

#2 – Allowance Method
Charge the reverse value of accounts receivables for doubtful customers to a contra
account called allowance for doubtful account. This keeps the P&L account unaffected
from bad debts and reporting of the direct loss against revenues can be avoided. However
writing-off the account at a future date is possible. For example:-
a) Mr. Unreal incurred losses and is not able to make payment at due dates.

b) Mr. Unreal goes bankrupted and will not pay at all.

c) Mr. Unreal has recovered from initial losses and wants to pay all of its previous debts.

Adjusting Entry for Bad Debts Expense

Companies provide services or sell goods for cash or on credit. Allowing credit tends to encourage
more sales.
However, businesses that allow credit are faced with the risk that their receivables may not be
collected.
Accounts receivable should be presented in the balance sheet at net realizable value, i.e. the most
probable amount that the company will be able to collect.
Net realizable value for accounts receivable is computed like this:
Accounts Receivable (Gross Amount) $100,000
Less: Allowance for Bad Debts 3,000
Accounts Receivable (Net Realizable Value) $ 97,000
Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the
estimated portion of the Accounts Receivable that the company will not be able to collect.
Take note that this amount is an estimate. There are several methods in estimating doubtful
accounts.The estimates are often based on the company's past experiences.
To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the
period. The adjusting entry for bad debts looks like this:
Dec 31 Bad Debts Expense xxx.xx
Allowance for Bad Debts xxx.xx
Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account; hence, it is
presented in the income statement. It represents the estimated uncollectible amount for credit
sales/revenues made during the period.
Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account that
represents the total estimated amount that the company will not be able to collect from its total
Accounts Receivable.
What is the difference between Bad Debts Expense and Allowance for Bad Debts?
Bad Debts Expense is an income statement account while the latter is a balance sheet account.
Bad Debts Expense represents the uncollectible amount for credit sales made during the period.
Allowance for Bad Debts, on the other hand, is the uncollectible portion of the entire Accounts
Receivable.
You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of Bad
Debts Expense and Allowance for Bad Debts. However, it is a good practice to use a uniform pair.
Some say that Bad Debts have a higher degree of uncollectibility that Doubtful Accounts. In actual
practice, however, the distinction is not really significant.
Here's an Example
Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period
will not be collected. The entry at the end of the period would be:
Dec 31 Bad Debts Expense 100.00
Allowance for Bad
100.00
Debts
Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair
every time. For example:
Doubtful Accounts
Dec 31 100.00
Expense
Allowance for Doubtful
100.00
Accounts
If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts
is $100, then the Accounts Receivable shall be presented in the balance sheet at $3,300 –
the net realizable value.
Accounts Receivable (Gross Amount) $ 3,400
Less: Allowance for Bad Debts 100
Accounts Receivable - Net Realizable Value $ 3,300
Salary Expense
Reversing entries are optional accounting procedures which may sometimes prove useful
in simplifying record keeping. A reversing entry is a journal entry to “undo” an adjusting
entry. Consider the following alternative sets of entries.
The first example does not utilize reversing entries. An adjusting entry was made to record
$2,000 of accrued salaries at the end of 20X3. The next payday occurred on January 15,
20X4, when $5,000 was paid to employees. The entry on that date required a debit to
Salaries Payable (for the $2,000 accrued at the end of 20X3) and Salaries Expense (for
$3,000 earned by employees during 20X4).
The next example revisits the same facts using reversing entries. The adjusting entry in
20X3 to record $2,000 of accrued salaries is the same. However, the first journal entry of
20X4 simply reverses the adjusting entry. On the following payday, January 15, 20X5, the
entire payment of $5,000 is recorded as expense.

Illustration Without Reversing Entries

Illustration With Reversing Entries

The net impact with reversing entries still records the correct amount of salary expense for
20X4 ($2,000 credit and $5,000 debit, produces the correct $3,000 net debit to Salaries
Expense). It may seem odd to credit an expense account on January 1, because, by itself,
it makes no sense. The credit only makes sense when coupled with the subsequent debit
on January 15. Notice from the following diagram that both approaches produce the same
final results:
 BY COMPARING THE ACCOUNTS AND AMOUNTS, NOTICE THAT THE SAME END
RESULT IS PRODUCED!

In practice, reversing entries will simplify the accounting process. For example, on the first
payday following the reversing entry, a “normal” journal entry can be made to record the
full amount of salaries paid as expense. This eliminates the need to give special
consideration to the impact of any prior adjusting entry.
Reversing entries would ordinarily be appropriate for those adjusting entries that involve
the recording of accrued revenues and expenses; specifically, those that involve future
cash flows. Importantly, whether reversing entries are used or not, the same result is
achieved!

Wages
It might be helpful to look at the accounting for both situations to see how difficult
bookkeeping can be without recording the reversing entries. Let’s look at let’s go
back to your accounting cycle example of Paul’s Guitar Shop.
In December, Paul accrued $250 of wages payable for the half of his employee’s
pay period that was in December but wasn’t paid until January. This end of the
year adjusting journal entry looked like this:
Accounting with the reversing entry:
Paul can reverse this wages accrual entry by debiting the wages payable
account and crediting the wages expense account. This effectively cancels out
the previous entry.

But wait, didn’t we zero out the wages expense account in last year’s closing
entries? Yes, we did. This reversing entry actually puts a negative balance in the
expense. You’ll see why in a second.
On January 7th, Paul pays his employee $500 for the two week pay period. Paul
can then record the payment by debiting the wages expense account for $500
and crediting the cash account for the same amount.

Since the expense account had a negative balance of $250 in it from our
reversing entry, the $500 payment entry will bring the balance up to positive
$250– in other words, the half of the wages that were incurred in January.
See how easy that is? Once the reversing entry is made, you can simply record
the payment entry just like any other payment entry.

Accounting without the reversing entry:

If Paul does not reverse last year’s accrual, he must keep track of the adjusting
journal entry when it comes time to make his payments. Since half of the wages
were expensed in December, Paul should only expense half of them in January.

On January 7th, Paul pays his employee $500 for the two week pay period. He
would debit wages expense for $250, debit wages payable for $250, and credit
cash for $500.

The net effect of both journal entries have the same overall effect. Cash is
decreased by $250. Wages payable is zeroed out and wages expense is
increased by $250. Making the reversing entry at the beginning of the period just
allows the accountant to forget about the adjusting journal entries made in the
prior year and go on accounting for the current year like normal.
As you can see from the T-Accounts above, both accounting method result in
the same balances. The left set of T-Accounts are the accounting entries made
with the reversing entry and the right T-Accounts are the entries made without
the reversing entry.