Page 125 - Accounting Principles (A Business Perspective)

This book is licensed under a Creative Commons Attribution 3.0 License

year, it transfers USD 800 from Rent Expense to Prepaid Rent. To simplify our approach, we will consistently debit
the asset when the asset will benefit more than the current accounting period.
Depreciation Just as prepaid insurance and prepaid rent indicate a gradual using up of a previously recorded

asset, so does depreciation. However, the overall time involved in using up a depreciable asset (such as a building)
is much longer and less definite than for prepaid expenses. Also, a prepaid expense generally involves a fairly small
amount of money. Depreciable assets, however, usually involve larger sums of money.
A depreciable asset is a manufactured asset such as a building, machine, vehicle, or piece of equipment that
provides service to a business. In time, these assets lose their utility because of (1) wear and tear from use or (2)
obsolescence due to technological change. Since companies gradually use up these assets over time, they record
depreciation expense on them. Depreciation expense is the amount of asset cost assigned as an expense to a

particular period. The process of recording depreciation expense is called depreciation accounting. The three
factors involved in computing depreciation expense are:
• Asset cost. The asset cost is the amount that a company paid to purchase the depreciable asset.
• Estimated residual value. The estimated residual value (scrap value) is the amount that the
company can probably sell the asset for at the end of its estimated useful life.
• Estimated useful life. The estimated useful life of an asset is the estimated time that a company can
use the asset. Useful life is an estimate, not an exact measurement, that a company must make in advance.
However, sometimes the useful life is determined by company policy (e.g. keep a fleet of automobiles for three

years).
Accountants use different methods for recording depreciation. The method illustrated here is the straight-line
method. We discuss other depreciation methods in Chapter 10. Straight-line depreciation assigns the same amount
of depreciation expense to each accounting period over the life of the asset. The depreciation formula
(straight-line) to compute straight-line depreciation for a one-year period is:
Asset cost – Estimated residual value
Annual deprecation=
Estimated years of usefullife
To illustrate the use of this formula, recall that on December 1, MicroTrain Company purchased four small
trucks at a cost of USD 40,000. The journal entry was:
2010
Dec. 1 Trucks 40,000
Cash 40,000
To record the purchase of four trucks.

The estimated residual value for each truck was USD 1,000, so MicroTrain estimated the total residual value for
all four trucks at USD 4,000. The company estimated the useful life of each truck to be four years. Using the
straight-line depreciation formula, MicroTrain calculated the annual depreciation on the trucks as follows:
USD40,000 – USD 4,000
Annual deprecation = =USD9,000
4years
The amount of depreciation expense for one month would be / of the annual amount. Thus, depreciation
1
12
expense for December is USD 9,000 ÷ 12 = USD 750.
The difference between an asset’s cost and its estimated residual value is an asset’s depreciable amount. To
satisfy the matching principle, the firm must allocate the depreciable amount as an expense to the various periods
in the asset’s useful life. It does this by debiting the amount of depreciation for a period to a depreciation expense

Accounting Principles: A Business Perspective 126 A Global Text