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How to Calculate Depreciation Expense

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

When a company buys an asset that will probably last for greater than one year, the cost of that asset is not counted as an immediate expense. Rather, the cost is spread out over several years in a process known as depreciation.

Straight-Line Depreciation

The most basic form of depreciation is known as straight-line depreciation. Using this method, the cost of the asset is spread out equally over the expected life of the asset.

Example: Daniel spends \$5,000 on a new piece of equipment for his carpentry business. He expects the equipment to last for 5 years, by which point it will likely be of no substantial value. Each year, \$1,000 of the equipment’s cost will be counted as an expense.

When Daniel first purchases the equipment, he would make the following journal entry:

 DR. Equipment 5,000 CR. Cash 5,000

Then, each year, Daniel would make the following entry to record Depreciation Expense for the equipment:

 Depreciation Expense 1,000 Accumulated Depreciation 1,000

Accumulated Depreciation is what’s known as a “contra account,” or more specifically, a “contra-asset account.” Contra accounts are used to offset other accounts. In this case, Accumulated Depreciation is used to offset Equipment.

At any given point, the net of the debit balance in Equipment, and the credit balance in Accumulated Depreciation gives us the net Equipment balance—sometimes referred to as “net book value.” In the example above, after the first year of depreciation expense, we would say that Equipment has a net book value of 4,000. (5,000 original cost, minus 1,000 Accumulated Depreciation.)

We make the credit entries to Accumulated Depreciation rather than directly to Equipment so that we:

1. Have a record of how much the asset originally cost, and
2. Have a record of how much depreciation has been charged against the asset already.

Example (continued): Eventually, after 5 years, Accumulated Depreciation will have a credit balance of 5,000 (the original cost of the asset). At this point—once the asset has zero net book value—Daniel will make the following entry to “write off” the asset:

 Accumulated Depreciation 5,000 Equipment 5,000

After making this entry, there will no longer be any balance in Equipment or Accumulated Depreciation.

Salvage Value

What if a business plans to use an asset for a few years, and then sell it before it becomes entirely worthless? In these cases, we use what is called “salvage value.” Salvage value (sometimes referred to as residual value) is the value that the asset is expected to have after the planned number of years of use.

Example:
Lydia spends \$11,000 on office furniture, which she plans to use for the next ten years, after which she believes it will have a value of approximately \$2,000. The furniture’s original cost, minus its expected salvage value is known as its depreciable cost—in this case, \$9,000.

Each year, Lydia will record \$900 of depreciation as follows:

 Depreciation Expense 900 Accumulated Depreciation 900

After ten years, Accumulated Depreciation will have a \$9,000 credit balance. If, at that point, Lydia does in fact sell the furniture for \$2,000, she’ll need to record the inflow of cash, and write off the Office Furniture and Accumulated Depreciation balances:

 Accumulated Depreciation 9,000 Cash 2,000 Office Furniture 11,000

Gain or Loss on Sale

Of course, it’s pretty unlikely that somebody can predict exactly what an asset’s salvage value will be several years from the date she bought the asset. When an asset is sold, if the amount of cash received is greater than the asset’s net book value, a gain must be recorded on the sale. (Gains work like revenue in that they have credit balances, and increase owners’ equity.)

If, however, the asset is sold for less than its net book value, a loss must be recorded. (Losses work like expenses: They have debit balances, and they decrease owners’ equity.)

Determining whether to make a gain entry or a loss entry is never too difficult: Just figure out whether an additional debit or credit is needed to make the journal entry balance.

Example (continued): If, after ten years, Lydia had sold the furniture for \$3,000 rather than \$2,000, she would record the transaction as follows:

 Cash 3,000 Accumulated Depreciation 9,000 Office Furniture 11,000 Gain on Sale of Furniture 1,000

Example (continued): If, however, Lydia had sold the furniture for only \$500, she would make the following entry:

 Cash 500 Accumulated Depreciation 9,000 Loss on Sale of Furniture 1,500 Office Furniture 11,000

Other Depreciation Methods

In addition to straight-line, there are a handful of other (more complicated) methods of depreciation that are also GAAP-approved. For example, the double declining balance method consists of multiplying the remaining net book value by a given percentage every year. The percentage used is equal to double the percentage that would be used in the first year of straight-line depreciation.

Example:
Randy purchases \$10,000 of equipment, which he plans to depreciate over five years. Using straight-line, Randy would be depreciating 20% of the value (100% ÷ five years) in the first year. Therefore, the double declining balance method will use 40% depreciation every year (2 x 20%). The depreciation for each of the first four years would be as follows:

 Year Net Book Value Depreciation Expense 1 \$10,000 x40% = \$4,000 2 \$6,000 x40% = \$2,400 3 \$3,600 x40% = \$1,440 4 \$2,160 x40% = \$864

Example (continued): Because the equipment is being depreciated over five years, Randy would record \$1,296 (that is, 2,160 – 864) of depreciation expense in the fifth year in order to reduce the asset’s net book value to zero.

Another GAAP-accepted method of depreciation is the units of production method. Under the units of production method, the rate at which an asset is depreciated is not a function of time, but rather a function of how much the asset is used.

Example: Bruce runs a business making leather jackets. He spends \$50,000 on a piece of equipment that is expected to last through the production of 5,000 jackets. Using the units of production method of depreciation, Bruce would depreciate the equipment each period based upon how many jackets were produced (at a rate of \$10 depreciation per jacket).

If, in a given month, Bruce’s business used the equipment to produce 150 jackets, the following entry would be used to record depreciation:

 Depreciation Expense 1,500 Accumulated Depreciation 1,500

Immaterial Asset Purchases

The concept of materiality plays a big role in how some assets are accounted for. For example, consider the case of a \$15 wastebasket. Given the fact that a wastebasket is almost certain to last for greater than one year, it should, theoretically, be depreciated over its expected useful life.

However—in terms of the impact on the company’s financial statements—the difference between depreciating the wastebasket and expensing the entire cost right away is clearly negligible. The benefit of the additional accounting accuracy is far outweighed by the hassle involved in making insignificant depreciation journal entries year after year. As a result, assets of this nature are generally expensed immediately upon purchase rather than depreciated over multiple years. Such a purchase would ordinarily be recorded as follows:

 Office Administrative Expense 15 Cash (or Accounts Payable) 15

Simple Summary

• Straight-line depreciation is the simplest depreciation method. Using straight-line, an asset’s cost is depreciated over its expected useful life, with an equal amount of depreciation being recorded each month.
• Accumulated depreciation—a contra-asset account—is used to keep track of how much depreciation has been recorded against an asset so far.
• An asset’s net book value is equal to its original cost, less the amount of accumulated depreciation that has been recorded against the asset.
• If an asset is sold for more than its net book value, a gain must be recorded. If it’s sold for less than net book value, a loss is recorded.
• Immaterial asset purchases tend to be expensed immediately rather than being depreciated.

 Accounting Made Simple: Accounting Explained in 100 Pages or Less
Topics Covered in the Book:
• How to read and prepare financial statements
• Preparing journal entries with debits and credits
• Cash method vs. accrual method
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "

How to Calculate Cost of Goods Sold (CoGS)

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

When using the periodic method of inventory, Cost of Goods Sold is calculated using the following equation:

Beginning Inventory + Inventory Purchases – End Inventory = Cost of Goods Sold

This equation makes perfect sense when you look at it piece by piece.

Beginning inventory, plus the amount of inventory purchased over the period gives you the total amount of inventory that could have been sold (sometimes known, understandably, as Cost of Goods Available for Sale).

We then assume that, if an item isn’t in inventory at the end of the period, it must have been sold. (And conversely, if an item is in ending inventory, it obviously wasn’t sold, hence the subtraction of the ending inventory balance when calculating CoGS).

EXAMPLE: Corina has a business selling books on eBay. An inventory count at the beginning of November shows that she has \$800 worth of inventory on hand. Over the month, she purchases another \$2,400 worth of books. Her inventory count at the end of November shows that she has \$600 of inventory on hand.

Using the equation above, we learn that Corina’s Cost of Goods Sold for November is \$2600, calculated as follows:

 Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold 800 + 2400 – 600 = 2600

Granted, this equation isn’t perfect. For instance, it doesn’t keep track of the cost of inventory theft. Any stolen items will accidentally get bundled up into CoGS, because:

1. They aren’t in inventory at the end of the period, and
2. There is no way to know which items were stolen as opposed to sold, because inventory isn’t being tracked item-by-item.

Assumptions Used in Calculating CoGS under the Periodic Method

Of course, the calculation of CoGS is a bit more complex out in the real world. For example, if a business is dealing with changing per-unit inventory costs, assumptions have to be made as to which ones were sold (the cheaper units or the more expensive units).

EXAMPLE: Maggie has a business selling t-shirts online. She gets all of her inventory from a single vendor. In the middle of April, the vendor raises its prices from \$3 per shirt to \$3.50 per shirt. If Maggie sells 100 shirts during April—and she has no way of knowing which of those shirts were purchased at which price—should her CoGS be \$300, \$350, or somewhere in between?

The answer depends upon which inventory-valuation method is used. The three most used methods are known as FIFO, LIFO, and Average Cost. Under GAAP, a business can use any of the three.

First-In, First-Out (FIFO)

Under the “First-In, First-Out” method of calculating CoGS, we assume that the oldest units of inventory are always sold first. So in the above example, we’d assume that Maggie sold all of her \$3 shirts before selling any of her \$3.50 shirts.

Last-In, First-Out (LIFO)

Under the “Last-In, First-Out” method, the opposite assumption is made. That is, we assume that all of the newest inventory is sold before any older units of inventory are sold. So, in the above example, we’d assume that Maggie sold all of her \$3.50 shirts before selling any of her \$3 shirts.

EXAMPLE (CONTINUED): At the beginning of April, Maggie’s inventory consisted of 50 shirts—all of which had been purchased at \$3 per shirt. Over the month, she purchased 100 shirts, 60 at \$3 per shirt, and 40 at \$3.50 per shirt. In total, Maggie’s Goods Available for Sale for April consists of 110 shirts at \$3 per shirt, and 40 shirts at \$3.50 per shirt.

If Maggie were to use the FIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be \$300. (She had 110 shirts that cost \$3, and FIFO assumes that all of the older units are sold before any newer units are sold.)

100 x 3 = 300

If Maggie were to use the LIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be \$320. (LIFO assumes that all 40 of the newer, \$3.50 shirts would have been sold, and the other 60 must have been \$3 shirts.)

(40 x 3.5) + (60 x 3) = 320

It’s worth pointing out that the two methods result not only in different Cost of Goods Sold for the period, but in different ending inventory balances as well.

Under FIFO—because we assumed that all 100 of the sold shirts were the older, \$3, shirts—it would be assumed that, at the end of April, her 50 remaining shirts would be made up of 10 shirts that were purchased at \$3 each, and 40 that were purchased at \$3.50 each. Grand total ending inventory balance: \$170.

In contrast, the LIFO method would assume that—because all of the newer shirts were sold—the remaining shirts must be the older, \$3 shirts. As such, Maggie’s ending inventory balance under LIFO is \$150.

Average Cost

The average cost method is just what it sounds like. It uses the beginning inventory balance and the purchases over the period to determine an average cost per unit. That average cost per unit is then used to determine both the CoGS and the ending inventory balance.

[Beginning Inventory + Purchases (in dollars)]
÷ [Beginning Inventory + Purchases (in units)]
= Average Cost per Unit

Average Cost per Unit x Units Sold = Cost of Goods Sold

Avgerage Cost per Unit x Units in Ending Inventory = Ending Inventory Balance

EXAMPLE (CONTINUED): Under the average cost method, Maggie’s average cost per shirt for April is calculated as follows:

Beginning Inventory: 50 shirts (\$3/shirt)
Purchases: 100 shirts (60 at \$3/shirt and 40 at \$3.50/shirt)

Her total units available for sale over the period is 150 shirts. Her total Cost of Goods Available for Sale is \$470 (110 shirts at \$3 each and 40 at \$3.50 each).

Maggie’s average cost per shirt = \$470/150 = \$3.13

Using an average cost/shirt of \$3.13, we can calculate the following:

• CoGS in April = \$313 (100 shirts x \$3.13/shirt)
• Ending Inventory = \$157 (50 shirts x \$3.13/shirt)

Simple Summary

• The perpetual method of inventory involves tracking each individual item of inventory on a minute-to-minute basis. It can be expensive to implement, but it improves and simplifies accounting.
• The periodic method of inventory involves doing an inventory count at the end of each period, then mathematically calculating Cost of Goods Sold.
• FIFO (first-in, first-out) is the assumption that the oldest units of inventory are sold before the newer units.
• LIFO (last-in, first-out) is the opposite assumption: The newest units of inventory are sold before older units are sold.
• The average cost method is a formula for calculating CoGS and ending inventory based upon the average cost per unit of inventory available for sale over a given period.

 Accounting Made Simple: Accounting Explained in 100 Pages or Less
Topics Covered in the Book:
• How to read and prepare financial statements
• Preparing journal entries with debits and credits
• Cash method vs. accrual method
A testimonial from a reader on Amazon:
"A quick tour of the ins and outs of accounting. Great introduction on the basics and keeps it simple. Short enough to be read in a day. I highly recommend this to any one looking for a crash course in accounting. "

American Funds in Your 401k and IRA?

From time to time, people ask me what I think about mutual funds run by American Funds. My answer is that it depends on the circumstances.

In my experience, if you’re considering using American Funds, you’re likely in one of two situations:

1. A commission-paid financial advisor is pitching you an American Funds portfolio, or
2. American Funds is one of the investment options in your 401(k).

If somebody is currently attempting to sell you an American Funds portfolio for your IRA or taxable account, I’d suggest politely declining. I’d also suggest finding another advisor — one not paid on commission.

American Funds aren’t the worst thing you could put your money into, but the reality is that there are better, less expensive options available. There’s really no need to pay a sales load or an expense ratio of almost 1% per year.

Expense ratios are an excellent predictor of future performance. In fact, some studies show that they’re the best predictor. In other words, one of the most reliable ways to improve the performance of your portfolio is to reduce the costs you’re paying for your investments. (Makes sense, right?)

High-cost fund companies (and the salespeople pushing their products) will go to great lengths to obscure the common sense importance of costs. Rather than focus on costs, they promote the performance of whichever of their funds have performed best lately — all the while ignoring the fact that past performance is basically worthless as a predictor of long-term future performance.

While I’d suggest against using American Funds in your IRA or taxable account, it’s actually quite likely that, if American Funds are available in your 401(k), they’re going to be one of your best options.

Why the big difference? Two reasons:

1. In a retirement plan at work, you’ll often get access to American Funds products without paying a sales load, and
2. It’s likely that the other options in your 401(k) aren’t any better.

My advice for choosing funds in your 401(k) is to determine the asset allocation you want for your portfolio, then research the available investment options to determine the lowest-cost way to implement that asset allocation. For many investors, that will mean using some American Funds products in their 401(k).

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