Last week, in Part 1 of Accounting for Assets, we began to explore the concepts of accounting for different types of assets. We learned about the fundamentals of conservatism and depreciation/amortization. Today we want to expand upon these concepts and look more closely at Fixed Assets using our example from last week. Do you remember, we purchased a new 'dongle die'. Now if you don't have a clue as to what a 'dongle die' is, then you are just going to have to go all the way back of our Accounting 101 mini-series in which our young entrepreneur formed his first company, a dongle making business.
In our example last week we purchased a new ‘dongle die’ for $1000.00 and paid cash (in the form of a check) from our Bank of Trust account to make the purchase. Now I know that $1000.00 doesn't sound like much, but for this example we are going to post this piece of equipment as a fixed asset and schedule it for depreciation.
Asset Accounting Part 1 Figure 1
We can actually record this transaction using a Check like the one below:
Check for Dongle Die - Fixed Asset
Now if we look at the results of this check in our Chart of Accounts we see:
COA - Dongle Die Original Cost
So we have posted the original cost of our fixed asset, now what about depreciation? Let's recall that Depreciation strives to ‘match’ the reported value of each assets to the practical worth of that asset. In order to accomplish this, depreciation is credited against the asset on the Balance Sheet and debited to Depreciation Expense on the Income Statement at various times (but at least annually) over the life of the asset.
Now last week we made a basic assumption in the case of our Dongle-die we purchased. That assumption was predicated on our believe that the Dongle-die should have a 5-year life expectancy, so decided to depreciate the die out over the full five-years (at 20% of the original cost per year). But I also noted that depreciation methods vary for purposes of both ‘book’ reporting and ‘tax’ reporting, and in last week's article, and in the posting below we are making some very basic assumptions regarding the depreciation of this asset. So, based upon those factors, our depreciation General Ledger entries at the end of the first year would appear as:
Asset Accounting Part 1 Figure 2
We can in fact enter such a journal entry in our books.
Journal Entry - Dongle-die Depreciation
And now if we look at an excerpt from our Chart of Accounts we see the results of this Journal Entry:
Dongle-die COA EOY Yr 1
Alright, alright. I can hear the comments already, "Murph, you are all wrong, you only bought the dongle-die 16 days before the end of the year and you posted an entire year's worth of depreciation." True, but give me a break folks, I am just giving you an example of 'how' you post the entry, and I said we were making a lot of assumptions for purposes of this example. Now that we have taken a look at some practical steps, let's delve a little deeper into the theoretical concepts behind depreciation.
So depreciation really begins by determining the useful life of any fixed asset. The useful life refers to the time period that an asset will be useful to the business (this is also know as the asset's economic life). The useful life is NOT the same as how long the asset will actually last (referred to as the physical life of the asset). Factors such as the age of the asset when it was acquired, how often it is used, environmental or use conditions, technological changes and advancements, and repair policies can all impact the useful life of an asset.
- Useful life refers to the period in which the asset is expected to be used that may include maintenance or repairs. It is usually less than the physical life.
- For example, when you buy a new vehicle the manufacturer may tell you it will last for 5 years. However, you know that a useful life like that is based on an assumption that the vehicle will only be driven 15 or 20 thousand miles per year. If you plan to drive the vehicle say 36 thousand miles per year, you can expect the vehicle to have a useful life shorter than the 5 years the manufacturer told you.
Well in the case of our dongle-die the manufacturer told us that we should expect the useful life of the die to be five years given normal use, wear and tear and scheduled maintenance. So we really don't have a long enough experience in the dongle business to expect the die to last otherwise. I mean we know that we can probably use it for more than 5 years, but we may not get the quality results if we do so. As such we were right in our assumption that the dongle-die should be depreciated out for five 'full' years.
So the next steps in the process of depreciation involves estimating the residual value of the asset. Residual value is the worth or recoverable value of any fixed asset at the end of its useful life. This value may also be known as 'salvage or scrap value'. When the estimated residual value is not of a significant amount, the we assume it to be 0 (zero).
- Residual value is important in accounting because the book value of a fixed asset can never be depreciated to a value below residual value.
- For example, if at the end of five years we decide to replace our recently purchased dongle-die with a new one, someone else may want to buy our old dongle-die. Its residual value is what a willing buyer would pay us. Now we might be able to look up in adds or on-line listings what similar 5-year-old dongle dies are selling for on the market today and that might help us judge the residual value. Another source of such information might be to ask the vendor from whom we purchased the asset what they would give us as a trade-in value in five years on a new one.
In the case of our dongle-die we didn't do our homework, we just made a basic assumption that the die would be 'all used up' at the end of the 5th year, but we now have reason to believe that we can get $100 for the die at the end of it's useful 5-year life.
Since depreciation begins in the year bought, and the first year’s depreciation should be prorated using the depreciation start date, we now have enough information to properly calculate the depreciation on our dongle-die.
Original Cost $1,000.00
Less Residual Value $ 100.00
Depreciation Lifetime 5 years
Depreciable Value $ 900.00
1st year's life 16 days out of 365 (16/365 = .043835)
Annual Depreciation $900.00/5 = $180.00
1st year's depreciation $180.00 * .043835 = $7.89
So really, when it comes right down to it, our depreciation at the end of the first year is only $7.89 for our dongle-die. Not much 'bang for the buck' there, is there?
Well, using these revised assumptions our depreciation schedule would look something like this:
Year 1 = $ 7.89, Year 2 = $180.00, Year 3 = $180.00, Year 4 = $180.00, Year 5 = $180.00 and Year 6 = $172.11 for a total of $900.00.
Next time, we will examine some alternative 'depreciation' methods as we continue to explore the concepts of 'Accounting for Assets.'