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Adjusting Process

Adjusting Entries for Depreciation

Depreciation of Fixed Assets and Adjusting Entries

Adjusting entries are needed for various fixed assets, such as property and equipment, which may depreciate in value over time. Journal entries are used to record depreciation of fixed assets using expense accounts.

If a company owns a fixed asset, which is a tangible asset used in the normal course of business, such as property, plant, and equipment, to generate revenue, there is one other adjusting entry needed. Estimated depreciation as an expense for a fixed asset must be recorded as an adjusted entry. Depreciation is the process of allocating the cost of property, plant, and equipment over their expected useful lives as an expense. Depreciation expense supports the matching principle, that is, matching or allocating the cost of the fixed asset to the revenue generated in each accounting period. Examples of fixed assets include buildings, machinery, equipment, vehicles such as aircraft and automobiles, furniture, and fixtures. The recording of depreciation expense in accounting aims to recognize the wear and tear and use of such fixed or long-term assets in generating revenue. Note that land is considered to be a fixed asset but that no depreciation expense is normally recognized for land, as land may appreciate and does not necessarily suffer wear and tear.

Fixed assets such as property and equipment may depreciate in value and must be recorded in journal entries. One type of fixed asset that an airline company would most likely own is an aircraft such as a Boeing 737 or an Airbus A320. Such aircraft, which cost millions of dollars, are used to generate an airline's main source of revenue, namely, flight revenue, and will benefit the company for many years. For example, Global Air buys a Boeing 737 on January 1 of this year for $84 million. As the Boeing 737 transports passengers and cargo, there is wear and tear and decline in usefulness over time, causing depreciation in value. By the same token, such flights generate revenue for Global Air.
An aircraft owned by an airline is an example of a fixed asset, which depreciates in value over time. Recording depreciation expense recognizes wear and tear and use of revenue-generating fixed assets.
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The process of recording depreciation expense allocates the cost of $84 million over the aircraft's useful life (say, 20 years), using a basic straight-line method, which gradually reduces the carrying amount of a fixed asset over its useful life. The recording of depreciation expense supports the matching principle. The accumulated depreciation will be recorded at the end of the company's designated period, which is a monthly period in this case.

The annual depreciation expense could be $84million/20years=$4.2million\$84\;\text{million}\mathbin{/}20\;\text{years}=\$4.2\;\text{million}. If the company records the depreciation expense monthly, the expense would be $4.2 million divided by 12 months, or $350,000 per month. The adjusting entry made, in this case at each month-end, for the Boeing 737 would be to debit (increase) depreciation expense and credit (increase) accumulated depreciation. Over the life of the asset, the depreciation expense is tracked in the accumulated depreciation account.

Accumulated Depreciation and Book Value of an Asset

Journal entries are used to record depreciation of fixed assets using contra asset accounts.

The accumulated depreciation account is an example of a contra account used to offset or reduce an asset account to its book value, or carrying value. A contra account is associated with another main account (in this case, the fixed asset account) and has a balance that is opposite to the normal balance of the main account. Its purpose is to keep a running total of how much depreciation expense has been booked to date and by how much to reduce the original cost of the asset on the balance sheet.

For example, after seven months (July 31), a Boeing 737's total depreciation expense (accumulated depreciation for seven months) is $2.45 million, that is 350,000x7=$2.45million350,000\;\text{x}\;7=\$2.45\;\text{million}. The Boeing 737's book value—the cost of the asset after its accumulated depreciation is subtracted—or carrying value, on Global Air's books at year-end will no longer be its original cost, which was $84 million. Its book value will be reduced due to depreciation and accumulated depreciation.

Adjusting entry at month-end July 31 depreciation expense: Every month-end, Global Air will debit depreciation expense for the same amount.

Month-End Adjusting Entry of Depreciation Expense

  Debit Credit
Depreciation expense, Boeing 737 $350,000  
      Accumulated depreciation, Boeing 737   $350,000

Excerpt from Global Air's Balance Sheet for Property, Plant, and Equipment: The book value, or carrying value, of an asset can be determined by reducing the asset cost by the accumulated depreciation balance.

Determining Book Value of Asset

Property, Plant, and Equipment Book Value (in $ millions)
Boeing 737 $84.00
Less: accumulated depreciation (January 1–July 31) ($2.45)
Book value at July 31 $81.55