Many transactions affect the revenue or expenses of two or more accounting periods. For example, a business may purchase equipment that last for many years, insurance policies that cover 12 months, or office supplies to last for several months. Each of these assets is gradually used up—that is, becomes expense. How do accountants allocate the cost of these assets to expense over a span of several accounting periods? The answer is adjusting entries.
Adjusting entries are made at the end of each accounting period. There are several different types of adjusting entries; in fact, many businesses make a dozen or more adjusting entries at the end of every accounting period. We start our introduction of this concept by the "end-of-period adjustments" with the entry to record depreciation expense, This is most common of all adjusting entries; every business that owns a building equipment must record depreciation expense at the end period.
Our definition of expanse is the cost Of goods a services used up in the process of earning revenue. Buildings and equipment are examples of goods that are purchased in advance but which are used up gradually over many accounting periods. Each year a portion of the usefulness of these assets expires, and a portion of their total cost should be recognized as depreciation expense. The term depreciation means the systematic allocation of the cost of an asset to expense over the accounting periods making up the asset s useful life,
Although depreciation expense occurs each month, it does not involve monthly transactions. In effect, depreciation expense is paid in advance when the related asset is originally acquired. Thus, adjusting entries are needed at the end of each accounting period to record the appropriate amount of depreciation expense. Failure to make these adjusting entries would result in understating the expenses of the period and consequently overstating net income.
The Plant purchased by Yahmads Heavy Equipment Company at a cost of $36,000 is estimated to have a useful life of 20 years. The purpose of the $36,000 expenditure was to provide a place in which to carry on the business and thereby to obtain revenue. After 20 years of use the building is expected to be worthless and the original cost of $36,000 will have been entirely consumed. In effect, the company has purchased 20 years of “plant services” at a total cost of $36,000. A portion of this cost expire during each year of use of the plant. If we assume that each - year’s operations should bear an equal share of the total cost (straight-line depreciation), the annual depreciation expense will amount to of $36,000, or $1,800. On a monthly basis, depreciation expense is $150 ($36,000 cost ÷ 240 months). There are alternative methods of spreading the cost of a depreciable asset over its useful life.
The journal entry to record depreciation of the building during October follows:
The depreciation expense account will appear in the income statement for October along with the other expenses of salaries, advertising, and telephone. The Accumulated Depreciation: Building account will appear in the balance sheet as a deduction from the Building account, as shown by the following illustration of a partial balance sheet:
The end result of crediting the Accumulated Depreciation: Building account is much the same as if the credit had been made to the Building account; that is, the net amount shown on the balance sheet for the building is reduced from $36,000 to $35,850. Although the credit side of a depreciation entry could be made directly to the asset account, it is customary and more efficient to record such credits in a separate account entitled
The original cost of the asset and the total amount of depreciation recorded over the years can more easily be determined from the ledger when separate accounts are maintained for the asset and for the accumulated depreciation.
Accumulated Depreciation: Building is an example of a contra-asset account, because it has a credit balance and is offset against an asset account (Building) to produce the proper balance sheet amount for the asset.
Depreciation on the office equipment of Yahmad's Heavy Equipment Company must also be recorded at the end of October. This equipment cost $5,400 and is assumed to have a useful life of 10 years. Monthly depreciation expense on the straight-line basis is, therefore, $45 computed by dividing the cost of $5,400 by the useful life of 120 months.
The journal entry is as follows:
No depreciation was recorded on the Plant and Office equipment for January, the month in which these assets were acquired, because regular operations did not begin until February. Generally, depreciation is not recognized until the business begins active operation and the assets are placed in use.
The journal entry by which depreciation is recorded at the end of the month is called an adjusting entry. The adjustment of certain asset accounts and related expense accounts is a necessary step at the end of each accounting period so that the information presented in the financial statements will be as accurate and complete as possible.
The Adjusted Trial Balance
After all the necessary adjusting entries have been journalized. An adjusted trial balance is prepared to prove that the ledger is still in balance. It also provides a complete listing of the account balances which are then in preparing the financial statements. The following adjusted trial balance differs from the trial balance because it includes accounts for depreciation expense and accumulated depreciation.