Journal Entries
May 21, 2021
Every company has fixed assets, and you’re probably reading this on one right now. Fixed assets are purchases your company makes that add value to the business and that help your company make money. The best examples are computers, office furniture and company cars. These are purchases that will benefit the business for more than a year.
The matching principle in GAAP accounting requires us to match revenues with the expenses that generate that revenue. But if you write off major asset purchases when you buy them, that violates matching: you get a big deduction the first year, but nothing after that, even though the company will continue to benefit from them for years to come. Those big swings in expenses distort income, making company performance seem worse or better than it really is. Depreciation is how we solve that problem.
Outside of the accounting world, depreciation means the decline in value of an item after purchase. In accounting, depreciation is the process of allocating the cost of an item over its anticipated useful life. This helps to ensure that company revenues are matched with the costs of assets used by a company to generate that revenue.
When assets are purchased, they are recorded at their historical cost in an asset account on the balance sheet. At the end of every accounting period, a depreciation journal entry is recorded as part of the usual periodic adjusting entries.
To calculate depreciation expense, you need to know four things:
- Cost. The depreciable basis of an asset includes all the costs to acquire the item and place it in service. This includes the purchase price, plus any shipping, taxes. installation, or customization costs you pay to get that item ready for use.
- Depreciation method – Straight-line (evenly over the useful life) vs. accelerated depreciation (double the rate, early in the life of the asset). Straight-line depreciation is the easiest to calculate, but for tax purposes, accelerated depreciation front-loads depreciation expense to provide a bigger tax deduction early on.
- Useful life – Each asset class has a different useful life. The most common classes we see are 5 years (computers) or 7 years (office furniture).
- Residual value or salvage value – What you can sell your asset for at the end of its useful life. Your basis for depreciation will be original cost minus salvage value. In practice, most accountants assume this is close enough to zero that it can be ignored.
For example, let’s say on April 1, an organization purchases a laptop for $1,000 and estimates that it will last five years with zero residual value. The annual depreciation expense will be $200 ($1,000 / 5 years), and the monthly depreciation expense will be $16.67, rounded to $16.70 ($1,000 / 60 months).
The journal entry to record the purchase of the laptop is as follows:
| Date | Account Name | DR | CR |
| 4/1/21 | Fixed Asset – Computers | $1,000 | |
| Cash | $1,000 |
Depreciation is recorded as a debit to a depreciation expense account and a credit to a contra asset account called accumulated depreciation. Contra accounts are used to track reductions in the valuation of an account without changing the balance in the original account. In the financial statements, depreciation expense shows up in the income statement, and accumulated depreciation is grouped with the fixed assets on the balance sheet.
Let’s look at the bookkeeping entry to record depreciation for our laptop:
| Date | Account Name | DR | CR |
| 4/30/21 | Depreciation Expense | $16.70 | |
| Accumulated Depreciation | $16.70 |
This depreciation journal entry will be made every month until the balance in the accumulated depreciation account for that asset equals the purchase price or until that asset is disposed of.
As a contra account, accumulated depreciation reduces the book value of that asset on the balance sheet. The net book value of an asset is determined by taking the sum of the fixed asset account – which has a debit balance – and the accumulated depreciation account – which has a credit balance. Over time, the net book value of an asset will decrease until its salvage value is reached.
It’s important to note that the book value of an asset may differ significantly from its market value. A good example is a car, which can lose 30% of its market value as soon as you drive it off the lot, but its book value on the balance sheet will still be pretty close to the purchase price. If the market value of an asset changes materially, U.S. GAAP only allows downward adjustments from historical cost, which are called impairment losses. This is a difference from IFRS, which allows for both upward and downward asset revaluation.
Let’s say that on May 1, 2025, the company replaces that laptop with a newer one, and sends the old one to be recycled. With four full years of depreciation, the accumulated depreciation account shows a credit balance for that laptop of $800. This means the net book value of the asset is $200 ($1,000 – $800). In the year of disposal, you write off any remaining value as a loss. Here’s the bookkeeping entry to record the disposal of the laptop:
| Date | Account Name | DR | CR |
| 5/1/25 | Accumulated Depreciation | $800 | |
| Loss on Disposal | $200 | ||
| Fixed Asset – Computers | $1,000 |
Other items of note:
Depreciation is a non-cash entry for your company, meaning no cash is going out of your bank account for this expense item. This becomes a factor in your statement of cash flows.
If you’re using different depreciation methods for your GAAP-basis financials and for tax purposes, you’ll have a book-tax difference for depreciation, which will go into calculating the company’s tax provision.
Intangible assets, such as trademarks or patents are not depreciated, but amortized. Amortization follows the same concept as depreciation, but the method is nearly always straight line.
Want to learn more about the details of journal entries? Check out our library of helpful posts right here.
I'm an expert in accounting and financial management with extensive experience in the field. Throughout my career, I've navigated the intricacies of Generally Accepted Accounting Principles (GAAP) and have a deep understanding of how businesses manage their fixed assets. My expertise is grounded in practical application, having worked with various companies to implement effective accounting practices.
Now, let's delve into the concepts presented in the article:
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Fixed Assets and Their Importance:
- Fixed assets are purchases that add value to a business and contribute to revenue generation. Examples include computers, office furniture, and company cars.
- These assets provide long-term benefits to the company, spanning more than a year.
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Matching Principle in GAAP Accounting:
- GAAP's matching principle requires the alignment of revenues with the expenses that generate those revenues.
- Writing off major asset purchases immediately violates matching, distorting the company's income presentation.
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Depreciation and Its Purpose:
- Depreciation in accounting is the process of allocating the cost of an asset over its expected useful life.
- It ensures that company revenues are accurately matched with the costs of assets used to generate revenue.
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Factors in Calculating Depreciation:
- Cost: The depreciable basis includes all costs to acquire, ship, install, or customize the asset.
- Depreciation Method: Straight-line vs. accelerated (common for tax purposes).
- Useful Life: Different asset classes have varying useful lives (e.g., 5 or 7 years).
- Residual Value: The estimated value of the asset at the end of its useful life.
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Depreciation Journal Entries:
- Journal entry example for a laptop purchase: Debit Fixed Asset - Computers, Credit Cash.
- Monthly depreciation entry: Debit Depreciation Expense, Credit Accumulated Depreciation.
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Accumulated Depreciation and Book Value:
- Accumulated Depreciation is a contra asset account that reduces the book value of an asset on the balance sheet.
- Net book value is the sum of the fixed asset account and accumulated depreciation.
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Disposal of Assets:
- When disposing of an asset, any remaining value is recorded as a loss.
- Example disposal entry: Debit Accumulated Depreciation, Debit Loss on Disposal, Credit Fixed Asset.
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Depreciation's Impact on Financial Statements:
- Depreciation is a non-cash entry, affecting the statement of cash flows.
- Differences in depreciation methods for GAAP and tax purposes result in book-tax differences impacting the company's tax provision.
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Intangible Assets and Amortization:
- Intangible assets like trademarks are not depreciated but amortized, following a straight-line method similar to depreciation.
Understanding and effectively managing these concepts is crucial for accurate financial reporting and decision-making within a business. If you have further questions or need additional clarification on any of these topics, feel free to ask.
