Double entry bookkeeping

In this lesson, recording transactions using T-accounts is explained. This is followed by an extension on the 'worksheet-method' of accounting, which was introduced in the previous lesson on financial statements - Using the accounting equation to record transactions. The main drawback of the 'worksheet-method' is that only the balances of balance sheet items are kept upto-date, whereas firms will need information on expenses and revenues as well. The extended method discussed here allows for creating an income statement as well as a balance sheet. It is the main method used to account for small businesses as well as multinationals. Finally, the full accounting cycle: from transactions to financial statements is illustrated.

Using T-accounts
In the simple 'worksheet method', each balance sheet item has their column in an Excel-like worksheet. Transactions are included in the rows, with 'entries' in the columns of the items that are affected by the transactions. Increases were added, and decreases subtracted. Even though this method would work (even for large volumes of transactions), this is not how accounting systems are organized. In practice every balance sheet item has their own record, called a T-account. A T-account, as the name suggests, looks like a capital T, the left side is defined as debit (or D) and the right side as credit (or C). On one side additions are written, and on the other side subtractions. Which side is + and which side - depends on the type of T-account. See the figure below for the debit-and-credit rules for the different T-accounts. Increases in assets (assets have a normal debit balance), are written on the debit side (and decreases on the credit side). Increases in liabilities and equity, which normally have a credit balance, are written on the credit side (and decreases on the debit side).

Debit-and-credit rules

Important: Debit and credit is not the same as 'plus' and 'minus' (nor the other way around). It is context dependent: for assets debit is plus (and credit minus), for liabilities and equity it is the other way around. A straightforward way to remember the debit and credit rules is that T-accounts increase on same side (debit or credit) as the side on where it is normally presented on the balance sheet. Since assets are presented on the balance sheets debit side, it is natural to write an increase on the debit side of an assets T-account (and decreases in the credit side). Similarly, liabilities and equity are presented on the credit side of the balance sheet. Hence, increases for these T-accounts are included on the credit side of the T-account (and decreases on the debit side). The value (balance) of a T-account is computed by balancing out the debit and credit side. For example, a T-account with total debits of 100 and total credits of 80 will have a debit balance of 20. A T-account can technically switch from one side to another. For example, a credit of 7 to a T-account with a debit balance of 5 will result in a credit balance of 2. This switching can take place for a bank account when the balance of the bank account switches from positive and negative.

Which T-accounts does the firm need? A company is free to chose the number of T-accounts. Depending on the nature of the business detail may be required in different areas. For example, a consultancy firm may have a single T-account vehicles to register the cost of the vehicles they own. A car rental firm probably requires more detail when it comes to accounting for the cars they own. Such a company could have T-accounts for different kind of cars such as sedans, SUVs and trucks. How transactions enter T-accounts The journal is a chronological list of all transactions that have occurred. Each transaction enters the journal in a journal entry. The journal entry lists the T-accounts and the amounts that change as a result of the transaction. The journal entry follows the debit and credit rules discussed above. As a result, a journal entry is always balanced (total amount of debits equals the total of credits). Example

Jan 1: The firm is incorporated on the 1st of January, 20X0. The owner, Betty, pays 40,000 cash for 10,000 shares. Following the accounting equation: Assets Cash 40,000 = = Liabilities 0 + + Equity Paid-in Capital 40,000

The following journal entry corresponds with this transaction: T-account Cash Paid-in capital Debit 40,000 Credit 40,000

Cash is an asset, which has a normal debit balance. Increases are written on the debit side of its T-account. Therefore, the 40,000 is written in the debit column of the journal entry. Paid-in capital is part of equity. For equity T-accounts, increases are written on the credit side. Thus, the 40,000 appears in the credit column for Paid-in capital.

Key points: - T-accounts are used to register transactions - T-accounts have a debit side (left) and a credit side (right) - increases in assets are recorded on the debit side, decreases on the credit side - increases in liabilities and equity are recorded on the credit side, decreases on the debit side - the number of T-accounts (i.e., the level of detail that can be provided) differs across firms - the journal is a list in chronological order of all transactions - each transaction is posted to the journal in the form of a journal entry - a journal entry is a list of all T-accounts affected by a transaction, where each T-account has a number added on the debit side, or on the credit side - a journal entry is balanced: the total of amounts debit equals the total amount of credits

Using temporary T-accounts

Using the accounting equation for keeping the books for an actual business has one main drawback, which is that it is cumbersome to infer what caused equity to change, as only the level (the value at a point in time) of equity is available. In other words: revenues and expenses are not separately recorded. Using temporary T-accounts overcomes this drawback. Instead of changing the T-account retained earnings as a result of revenues or expenses, additional T-accounts are used (such as sales, wages expense, interest expense, etc.). These T-accounts are called temporary Taccounts, as at the end of the accounting period their balances are booked into retained earnings. This way, the next periods income statement starts with all zeros, while at the same time getting the balance sheet back into balance (as net income needs to be added to retained earnings). The balance sheet T-accounts are called permanent, because they are not cleared at years end. Permanent T-accounts will show the amount or 'stock' at some point in time: Value = Beginning value + increases - decreases = Ending value Temporary T-accounts will show the change, or 'flow', since the beginning balance is set to zero for these T-accounts: Value = 0 + increases - decreases = Change The debit and credit rules for temporary T-accounts follow those of equity. That means that if equity increases because of revenue, a temporary T-account is credited. If equity is reduced because of an expense, a temporary T-account is debited. Using the same examples as above to illustrate the use of temporary T-accounts.

Example

Jan 15: ABCD Inc receives 3,000 cash for services delivered in January. Cash (an asset) increases by 3,000 and retained earnings (equity) increases by 3,000. Instead of crediting retained earnings, another (temporary) T-account sales is used. T-account Cash Sales Debit 3,000 Credit 3,000

Jan 26: ABCD joins the Association of Landscapers, and receives an invoice of 400 to be payable in February. Instead of debiting retained earnings, another (temporary) T-account operating expenses is used. T-account Operating expenses Accounts payable Debit 400 Credit 400

Key points: - T-accounts for the balance sheet are called permanent T-accounts; the end of year balance is carried over to the next year - T-accounts that record changes in retained earnings are called temporary T-accounts - the end of year balance for all temporary T-accounts is carried over to Retained earnings so that the next periods opening balance for each temporary T-account is zero

From transactions to financial statements

Some readers may prefer to refer to the comprehensive example before studying the various steps involved as described in this section. There are several steps from the recording of financial transactions to constructing the financial statements (each step is explained in more detail below): - recording the transaction in a journal entry - posting the journal entry to a log called the journal - updating the ledger which holds all T-accounts to reflect the newly posted journal entry - at years end, adjusting entries are made - at years end, temporary T-accounts are used to construct the income statement, which is added to retained earnings, and dividends declared are subtracted from retained earnings; in this step all temporary T-accounts are reset to zero - at years end, the permanent T-accounts (included the updated retained earnings) are used to construct the balance sheet

recording the transaction in a journal entry As discussed above, transactions are recorded on T-accounts that are impacted by the transaction. For example, when a firm pays the electricity bill, the T-accounts cash and electricity expenses need to be updated with the amount paid. Not all transactions are recorded. Usually when parties come to an agreement, but neither party performs their part of the deal, no transaction is recorded. For example, a customer places an order (which is legally binding), but does not pay yet. Also, the firm has not made a delivery. Only if at least one party delivers (either the customer pays, or the firm makes a delivery), a journal entry is made. For accounting purposes, a transaction can also be the mere passing of time. Consider for example the effect of time on the value of a loan. A loan that is interest bearing will increase when time passes by. Journal entries that are made at years end to update the financial statements are called end of year adjusting entries. posting the journal entry to the log called the journal The journal is a list of all journal entries that were made (in chronological order). It is used as a reference so that at a later point in time people can easily see which journal entries were made on a specific date. It is not helpful in constructing the actual values of T-accounts, as you will need to work through the whole journal to collect all entries to some T-account. For this purpose, the ledger is used (discussed next). updating the ledger which holds all T-accounts to reflect the newly posted journal entry The ledger is a collection of all T-accounts and contains all the changes to these T-accounts. So, if you want to verify whether or not the actual amount of cash equals the amount of cash in the books, it can easily be determined by accessing the T-account cash from the ledger. This Taccount will show all transactions involving the receipt or payment of cash and will show the balance. Tax authorities require firms to keep several years of history of the ledger. With the ledger, the tax authorities can easily verify whether or not the firm has correctly applied fiscal law in the audited years. at years end, adjusting entries are made At years end, it is common that assets and liabilities need to be adjusted. For example, the firm has long term assets that gradually reduce in value. So, at years end, the decline in value for the period needs to be accounted for. Also, the liabilities may have changed. For example, over time, interest accrues on interest bearing liabilities. The adjustments are booked with a journal entry and posted to the journal, just as any other transaction.

at years end, temporary T-accounts are used to construct the income statement, which is added to retained earnings, and dividends declared are subtracted from retained earnings; in this step all temporary T-accounts are reset to zero In the process of making the financial statements, a list of all T-accounts with their balances is constructed, which is called the trial balance. It is important to realize that the trial balance is not a balance sheet, but rather a list of temporary T-accounts (expenses and revenues and dividends declared) as well as permanent T-accounts (assets, liabilities and equity). The temporary T-accounts related to expenses and revenues are used to make the income statement, where net income equals total revenues minus total expenses. As the trial balance is balanced (total debits equal total credits), net income is implicitly included twice in the trial balance. First, it is the balance of the temporary T-accounts. In case of a profit, the net balance of the temporary T-accounts will be a credit balance. Second, net income will be the net balance of the permanent T-accounts. In case of a profit, assets will have a higher balance than liabilities and equity. When temporary T-accounts are used, revenues and expenses were no longer added to retained earnings. In other words, net income needs to be added to retained earnings to have a balanced balance sheet. When net income is know, the statement of retained earnings can be computed. During the year, all changes in retained earnings are booked on temporary T-accounts. Thus, retained earnings is not used during the year. Hence, the balance of this T-account on the trial balance will be last years ending balance. So, at years end this T-account needs to be updated. Retained earnings increases with net income of the year, and decreases with dividends declared. This step is performed by making a journal entry which resets all temporary T-accounts to zero, and transferring the balance to retained earnings.

Example

Consider the following trial balance: T-account Sales Wages expense Rental expense Dividend declared Cash Accounts receivable Real estate Paid-in capital Retained earnings Bank loan Interest payable Totals Debit 50 30 15 30 100 150 20 50 200 5 375 Credit 100

375

the journal entry to close the books is the following: T-account Sales Wages expense Rental expense Dividend declared Retained earnings Debit 100 Credit 50 30 15 5

Notice that all temporary T-accounts will have zero balances as a result of this entry. Even though net income is 20 (=100 50 30), retained earnings will increase by 5, as during the year 15 had been paid out as a dividend. It is also possible to use an additional temporary T-account 'Profit summary'. In this case, first all temporary T-accounts are cleared against this T-account (and not retained earnings). As a second step, the profit summary is added to retained earnings. The ending balance of retained earnings is the same for either method. at years end, the permanent T-accounts (included the updated retained earnings) are used to construct the balance sheet

When the statement of retained earnings is made, construction of the balance sheet is straightforward. All permanent T-accounts (and their balances) are taken from the trial balance, while using the updated value for the balance of retained earnings. This will result in a balance sheet where total debits equal total credits. Key points: - journal entry are posted to the journal, which is a log with all journal entries made in chronological order - the ledger is the collection of all T-accounts and all debits and credits to these T-accounts - at years end, adjusting entries are needed to make sure all assets and liabilities are included for the correct amounts - the trial balance is a list of all T-accounts (whether temporary, or permanent) and their balances, where the total of all debit balances equal the total of all credit balances - in the trial balance, the balance of retained earnings will be last years balance, as retained earnings is not used during the year (instead during the year temporary T-accounts are used for expenses, revenues and dividends) - after closing the books, retained earnings increases with net income, and decreases with dividends - the income statement is showing revenues minus expenses (which are temporary T-accounts) - the statement of retained earnings shows the beginning balance of retained earnings to which net income is added and dividends are subtracted, resulting in the end of year retained earnings - the balance sheet shows the balances of all permanent T-accounts

Comprehensive example: From transactions to financial statements

This section extends the example introduced in Financial statements: Using the accounting equation to record transactions. For these transactions, journal entries are made and entered into the journal, updating the ledger, etcetera, resulting in the financial statements. This example does not include adjusting entries. Examples on adjusting entries are included in the next lesson accrual accounting.

Accrual accounting

The operating section of the cash flow statement shows the firms performance at a cash basis. The cash flow from operations is the amount of cash that has been generated with day-to-day operations. The period in which the cash is received or paid, is also the same as the period where it is included in computing the cash flow from operations. This is called cash accounting. In practice however, most organizations use 'accrual accounting'. With accrual accounting performance measurement is not solely determined by cash flows. Accounting principles such as IFRS and U.S. GAAP prescribe when revenues and expenses need to be recorded.

Accrual accounting: allocating cash flows to periods

The income statement is based on accrual accounting. This means that it is not necessary that the cash flow is in the same period as the revenue/expense. In other words, with accrual accounting cash flows are allocated to periods. When a customer pays money to the firm, this cash inflow can be a revenue in a period prior to the cash inflow, the same period, or a future period. The same holds for cash outflows: a cash outflow can be expensed in a period prior to payment, the same period, or a later period. Accounting principles (discussed next) determine the period to which the cash flow is allocated. With accrual accounting, any possible transaction can be classified in either of six possibilities, which are shown in the figure below. In the upper half, it shows the three possible treatments of cash outflows. In the lower half, it shows the possibilities for cash inflows.

In the first column, the period of the cash flow is the same as the period of the expense/ revenue. In this column, accrual accounting yields the same result as cash accounting.

In the second column we see deferred accruals. That means, the period of the expense/revenue is in a later period than the cash flow. In case of a cash outflow the payment is capitalized as an asset, because it is considered to have future value. In a later period, when the asset is reduced in value, the asset is expensed. In the case of a cash inflow, a liability is increased. As the cash is received, but the firm has not delivered/rendered the products/services, the firm will have an obligation to do so. In a later period, when the firm has fulfilled its obligations, the liability is reduced and revenue is recognized. In both situations, we see that the cash flow is parked on

the balance sheet. Thats where the accrual in accrual accounting is coming from: cash flows accrue to the balance sheet. The opposite situation is depicted in column three. In a period prior to the cash flow, the expense/revenue is recognized. The resulting accruals are called accrued accruals. The term accrued refers to the fact that the cash flow is anticipated. In the cash of an anticipated cash outflow, an expense is recognized in an earlier period. At the same time of the expense, a liability is recognized. The liability reflects the fact that the firm has an obligation, in this case, to pay money. When the money is paid, the liability is reduced, and cash is reduced. In the case of an anticipated cash inflow a revenue is booked in an earlier period than the period of the cash inflow. At the time of the revenue, an asset is recognized to reflect the fact that a customer will pay money to the firm in the future. At the time of the cash inflow, this asset is reduced (because the customer has paid), and cash increases. Again, the balance sheet is used to bridge timing differences between the time of the expense/revenue and the time of the cash flow.

Key points: - Cash accounting: the expense/revenue is recognized at time of the cash flow - Accrual accounting: cash flows are allocated as expense/revenue to periods using accounting principles - Deferred accruals: the expense/revenue is in a later period than the period of the cash flow - Accrued accruals: the expense/revenue is in a earlier period than the period of the cash flow - The balance sheet is used to bridge timing differences between the period of expense/revenue and the period of the cash flow

Two main principles of accrual accounting

Accrual accounting is very flexible, and as a result it is open to manipulation. However, accounting principles restrict this flexibility so that the financial statements reflect the economic reality. (Large firms have their financial statements audited by an external auditor for increased assurance that the accounting principles have been applied correctly.) There are two main accounting principles: the revenue recognition rule determines in which period incoming cash flows need to be recognized as revenue and the matching principle tells in which period an outgoing cash flow needs to be expensed. The revenue recognition principle states that revenues are earned in the period where the product is delivered or the service has been rendered, regardless in which period the customer pays the firm. The matching principle states that cash outflows should be booked as an expense in the period where they help to generate revenue.

Key points: - accrual accounting is very flexible; accounting principles limit this flexibility so that opportunities to cook the books are restricted, and, (ideally) the financial statements represent the economic reality - the revenue recognition principle states that revenue is earned in the period when the products are delivered or services rendered - the matching principle states that expenses need to be booked (matched) in the period where they help to generate revenue

Accounts receivable

Uncollectibility of accounts receivable

Accounts receivable is an asset which is the result of accrual accounting. The firm has delivered products or rendered services (hence, revenue has been recognized), but no cash has been received, as the firm is allowing the customer to pay at a later point in time. Example

The firm sells products with a cost of 100 for 120 to a customer on account. The firm uses the perpetual inventory system. The journal entry of this transaction is: T-account Accounts receivable Sales Cost of goods sold Inventory Debit 120 100 100 Credit 120

The nominal value of accounts receivable is the legal claim that the firm has on the customers. If all customers pay in full, this is the amount that the firm will collect. However, it is common that some customers end up not paying. The net value of accounts receivable is the nominal amount minus an allowance for uncollectibility. Thus, net accounts receivables is the amount that the firm expects to collect. Example

In their annual report over 2008, Google presents their accounts receivable after deducting the allowance for uncollectible accounts receivable (annual report). The net value of accounts receivable is $2,163 million and $2,642 million for 2007 and 2008, respectively. The allowance for 2007 is $33 million, and for $80 for 2008. The percentage that Google expects to be uncollectible is 1.5% (=33/(33+2163)) for 2007 and 2.9% (=80/(80+2642)) for 2008. The benefit of allowing customers credit consist of the gain on the additional sales that allowing the credit generates. The cost is the risk that accounts will end up uncollectible. To mitigate this

risk, it is common practice to perform a credit check before a firm sells products/services to a customer on account. Nevertheless, it is likely that some customers will not be able to pay, as eliminating the risk on nonpayment could very well adversely affect sales. In this section I will focus on how firms account for uncollectible accounts. Key points: - nominal accounts receivable refers to the legal claim of the firm on its customers - the allowance for uncollectible accounts is the amount that the firm expects not to collect - net accounts receivable is the amount that the firm will be able to collect, which equals nominal accounts receivable minus the allowance for uncollectible accounts

Direct write-off method

Using the direct write-off method means that no allowance is made, and that the company writes down accounts receivable once they are uncollectible. When an account receivable is written off, it is expensed: bad debt expense x accounts receivable x There are two drawbacks of this method. First, applying the matching principle implies that the cost of the uncollectible accounts need to be expensed in the period of the sale. Giving credit to customers helps to generate sales (if this were not the case, the firm would simply demand payment at time of delivery). Thus, not creating an allowance violates the matching principle. Second, accounts receivable are at the nominal value, whereas the true value (the amount that is expected to be collectible) is probably lower. The next two methods overcome these drawbacks. Key points: - application of the matching principle implies that the expenses related to uncollectible accounts need to be booked in the period where the sales were made - with the direct write-off method the expense is booked in the period when the account is uncollectible, which is not in accordance with the matching principle

Percentage of sales method

With the percentages of sales method an allowance is created, as the name suggest, with a percentage of every sale. From past experience the firm learns which percentage of sales eventually turns out to be uncollectible. Each time the firm sells on account, this percentage of the sales is booked as an expense and added to the allowance. When at a later point in time an uncollectible invoice needs to be written off, the allowance is used as a buffer. Expenses are incurred to increase or form an allowance at the period of the sale, thus satisfying the matching principle. Subsequently, the allowance can be used to write off worthless receivables without the need to book an expense. At the end of the period, the allowance is subtracted from the nominal value of accounts receivable, resulting in net accounts receivable.

Example

From past experience, the firm knows that 2% of sales on account in uncollectible. Sales for the period amount to 400,000. The periods beginning credit balance of the allowance for uncollectible accounts is 5,000. The journal entry to book the bad debt expense is: T-account Bad debt expense Allowance for uncollectible accounts Debit 8,000 Credit 8,000

During the period, invoices for an amount of 9,000 are written off. The corresponding journal entry is: T-account Allowance for uncollectible accounts Accounts receivable Debit 9,000 Credit 9,000

Suppose end of period accounts receivable (after the above journal entry) amounts to 500,000. The presentation of accounts receivable on the balance sheet will be: Accounts receivable, nominal Allowance for uncollectible accounts Accounts receivable, net 500,000 -4,000 _______ 496,000

Key points: - with the percentage of sales method the firm books expenses at the time of the sale into an allowance, which is used when invoices turn out to be uncollectible

Ageing of accounts method

With the ageing of accounts method also an allowance created. Unlike the percentage of sales method, the expense is not booked at time of sales, but at the periods end instead. In addition, the amount of the expense is not related to the sales, but it is reverse-engineered from a targeted balance of the allowance. The ageing of accounts procedure results in an expected uncollectible amount for the accounts receivable at the periods end. It attributes a probability of uncollectibility depending on the age of the invoice. The older the invoice, the more likely it is it will be uncollectible. These percentages are again based on past experience. The uncollectible amount for total accounts receivable is the sum of the uncollectible amounts for each individual invoice. The expected uncollectible amount is the target balance of the allowance. The bad debt expense for the period is the difference between the targeted balance of the allowance and the current balance. Example

End of year accounts receivable is 250,000. The allowance for uncollectible accounts has a debit balance of 5,000. The ageing of accounts procedure indicates that 7,000 is expected to be uncollectible. The target balance of the allowance is 7,000 credit. The current balance is 5,000 debit, this means bad debt expense is 12,000. T-account Bad debt expense allowance for uncollectible accounts Debit 12,000 Credit 12,000

Key points: - the ageing of accounts method creates the allowance at years end; the expense in this method is the amount that is needed to get the allowance to the amount that is expected to be uncollectible

Management discretion
The percentage of sales method to account for uncollectible accounts is not allowed under IFRS. The IASB (standard setting body) believes that management has too much discretion to estimate the percentage that is used to calculate the expense. The concern is that if earnings is a little low (or too high), management will use this discretion to use a lower (or higher) percentage in order to smooth earnings. Also, even an unmanaged percentage can turn out to be too low or too high. After several years the allowance it could an unrealistic number, totally unrelated with the true risk in accounts receivable.

The ageing of accounts method is allowed under IFRS. Even though there is discretion with this method as well, the allowance is directly related to the risk assessment of end of the periods accounts receivable. It is possible to use both methods, by applying the percentage of sales during the year and at years end use the ageing of accounts method so that the allowance reflects the risk in accounts receivable. This approach combines the advantage of matching of the percentage of sales method and the risk assessment of the ageing of accounts method. This approach is allowed under IFRS.

Key points: - IFRS does not allow the percentage of sales method, because the end of year value of the allowance is not directly related with the risk assessment in end of year accounts receivables (instead, it is directly related to the sales in the past)

Current assets versus long term assets

The difference between current and long term assets is that current assets are converted/used within a single operating cycle (inventory, work in progress, accounts receivable, etc), whereas long term assets are used for multiple operating cycles (machines, buildings, etc). There are three types of long term assets: long term tangible assets, such as machines and buildings, long term intangible assets such as patents and trademarks and long term financial assets such as shares held in other companies. In this tutorial I focus on long term tangible assets. Many of the principles discussed here can be applied to intangible assets. Accounting for financial assets however, has some distinct features. I intend to discuss accounting for (long term) financial assets in a separate tutorial at a future point in time. Key points: - current assets are converted or used within a single operating cycle - long term assets are used multiple operating cycles

Purchase (or development) of long term assets

First, it needs to be determined if accounting principles allow for the asset to be recognized. The accounting treatment under IFRS (and also under US GAAP) differs for tangible and intangible assets. The requirements for capitalizing self developed (as opposed to purchased) intangible assets are most restrictive. The rationale behind this is that the valuation for these assets is most uncertain. (If time permits, I hope to write several tutorials on IFRS.) If accounting principles allow recognition of an asset, the next issue is which items can be included, and which items need to be expensed. The basic rule here is that when recognizing the asset is allowed all money that is spent to get the asset up and running is capitalized as part as the cost of the asset. Example

The following items can be capitalized when the firm purchases a machine. The machine itself, transportation (getting the machine in place), fees paid for having the machine installed and tested, the cost of a trial run, and alike. If the firms own personnel is involved with installing the machine, their wages expenses can be allocated to the machine as well. Examples that are excluded from the asset and consequently are expensed include training of personnel to learn how to use the machine, (unexpected) damages while installing the machine, or the drinks and snacks to celebrate the machines successful launch.

Key points: - accounting principles determine which assets can be recognized, and which cannot; regulation is most restrictive on capitalizing intangible assets that are self developed (such as brand names) - if an asset can be recognized, the items that are spent to get the asset up and running are allowed to be capitalized

Depreciation methods
During the economic lifetime the value of the asset is reduced (expensed). This expense is called depletion for natural resources, depreciation for other tangible long term assets, and amortization for intangible long term assets. Although other methods exist, I consider the two most common depreciation methods: the straight line method and the declining balance method. straight line depreciation As the name suggests, the straight line method results in a fixed amount for each period of the assets economic life time. The depreciable amount is the amount that needs to be expensed in total, which is the cost minus the residual value. The residual value is the amount that the firm expects to receive when the asset is disposed of at the end of the economic lifetime. Thus, the yearly depreciation expense is the depreciable amount divided by the economic lifetime. Depreciation is the decline in value of the asset. Instead of deducting depreciation from the assets T-account, it is common practice to create an additional T-account (called contra Taccount) where the depreciation is added to. Thus, every year the depreciation is credited to this T-account. Technically, a T-account with a credit balance can be included on the debit side of the balance sheet. In that case, the sign flips. Thus, accumulated depreciation is subtracted from the cost, resulting in the carrying value, which is also called net value or book value. (Presenting accumulated depreciation on the credit side would of course result in a balanced balance sheet. However, it would imply that accumulated depreciation is a liability, which it is not.)

Example At the beginning of the year, the firm buys new equipment for 10,000 cash with an estimated residual value of 1,000 and an economic lifetime of 4 years. The firm uses the straight line method. Recording the purchase: T-account Equipment Cash Debit 10,000 Credit 10,000

Alternative 1: recording depreciation expense without a contra T-account: T-account Depreciation expense Equipment Debit 2,250 Credit 2,250

Alternative 2: recording depreciation expense with a contra T-account: T-account Depreciation expense Accumulated depreciation, equipment Debit 2,250 Credit 2,250

The presentation on the balance sheet after 3 years is as follows: Alternative 1 (without a contra T-account) Equipment, net Alternative 2 (with a contra T-account) Equipment, cost Accumulated depreciation, equipment Equipment, net the declining balance method An alternative method is the declining balance method. Where the straight line method is a percentage of the depreciable amount, with the declining balance method the depreciation expense is a percentage of the book value of the asset. As the book value declines over time, so does the depreciation expense. In the year that applying this rule would result in a book value below the residual value, the firm switches to straight line deprecation for the remaining year(s).

3,250

10,000 -6,750 ______ 3,250

Example

At the beginning of the year, the firm buys a new machine for 20,000 cash with an estimated residual value of 4,000 and an economic lifetime of 6 years. The firm uses the declining balance method using 40%. The depreciation in year 1: 40% x 20,000 = 8,000 The depreciation in year 2: 40% x 12,000 = 4,800 The depreciation in year 3: 40% x 7,200 = 2,880 The depreciation in year 4: 40% x 4,320 = 1,728 106.66 The depreciation in year 5: 106.66 The depreciation in year 6: 106.67 In the fourth year the firm switches to straight line depreciation as an additional depreciation of 1,728 would result in a book value below the residual value of 4,000. The double declining balance is a special case of the declining balance method, where the percentage used is 200% divided by the economic lifetime. Example

The firm has purchased equipment with an economic lifetime of 10 years. The percentage that would be used with the double declining balance method would be 20% (=200% / 10 years). Key points: - the depreciable amount is the total depreciation over the economic lifetime and equals cost minus the residual value - usually separate T-accounts are used to record historic cost and cumulative depreciation - carrying value (book value, or net value of assets) equals cost minus cumulative depreciation - with the straight line method the yearly depreciation is constant: the depreciable amount divided by the number of years - with the declining balance method the yearly depreciation equals a percentage of the book value - the double declining balance method uses 200% divided by the economic lifetime as the percentage

Change in estimates
It is possible that changes occur during the economic lifetime of the asset. Its value may change, the economic lifetime may change, or the estimate of the residual value could be revised. When historic cost is the basis for valuation (which usually is the cast) and the fair value of the asset increases in value, no change is made to the value of the asset, nor to the depreciation schedule. However, under IFRS it is possible to opt for fair value valuation for long term assets. I intend to write an separate tutorial on this issue. However, when the fair value of the asset decreases below the book value of the asset, the asset needs to be written down to the lower fair value. This is the application of the lower of cost or market-rule. When the economic lifetime or estimates of the residual value change, no correction is made to catch up or undo past years depreciation. Instead, the depreciation schedule is adapted to fit the new economic lifetime and residual value.

Example

Beginning of year 1, the firm has purchased a machine for 10,000, an economic lifetime of 10 years, and an estimated residual value of 1,000. Hence, the firm depreciates 900 a year. After 5 years, when the book value is 5,500, management realizes the actual economic lifetime is only 8 years, with a residual value of 2,000. For the remaining 3 years, the firm will depreciate 1,166.66 per year (5,500 - 2,000 divided by 3 years). Key points: - when the firm uses historic cost as the basis for valuation, the firm will need to apply the lower of cost or market- rule - the lower of cost or market- rule dictates that assets are not revalued upwards when the fair value of the asset increases, but need to be market down to the fair value if the fair value would drop below the book value of the asset - if during the economic lifetime the estimated life time changes, or the estimated residual value changes, the depreciation schedule is adapted such that the remaining depreciable amount is depreciated over the remaining economic lifetime

Sale of long term assets

When the asset is disposed or sold, a gain or loss is realized. Example

Beginning of year 1, the firm has purchased a machine for 10,000, an economic lifetime of 10 years, and an estimated residual value of 1,000. Hence, the firm depreciates 900 a year. After 5 years, when the book value is 5,500, the firm sells the machine for 3,000 cash. The journal entry of the transaction is: T-account Cash Loss on sale machine Accumulated depreciation, machine Machine, cost Debit 3,000 2,500 4,500 Credit

10,000

Key points: - When the asset is disposed or sold, a gain or loss is realized - When a contra T-account is used for accumulated depreciation, the cost as well as the accumulated depreciation are removed from the books
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