Buying a van is not spending 30,000
By now you can handle the two great families of period-end fixes. With an accrual the work comes before the cash; with a deferral the cash comes before the work, and each period you unwind a little of it into the income statement. This guide is about a third, slightly stranger case that hides inside the deferral family — what happens when the thing you paid for in advance is not a year of insurance but a delivery van that will serve the business for five years. The fix is called depreciation, and like every adjustment in this rung it touches the income statement and the balance sheet but never goes near cash.
Start with the temptation we must resist. You write a cheque for 30,000 and the van rolls onto the lot. It feels like you just spent 30,000 — so why not record a 30,000 expense and be done with it? Because the cash payment did not destroy value; it *converted* one asset into another. You traded 30,000 of cash for 30,000 of van. The day after the purchase you are exactly as wealthy as the day before — the bank balance fell, but a van of equal worth took its place. Recording an expense now would falsely claim the business is 30,000 poorer the moment it bought a useful machine.
So the purchase is not an expense — it is capitalized, meaning the cost is parked on the balance sheet as an asset, part of what accountants call property, plant and equipment. That decision, capitalizing rather than expensing, is the first half of the story. But here is the catch the insurance example already taught you: a benefit paid for in advance gets *used up* over time. The van will not last forever. Over five hard years of deliveries it will wear out, and at the end it will be worth almost nothing. Somewhere across those five years, the 30,000 really does become an expense — just not all at once, and not on day one.
Spreading the cost over the years that use it
Depreciation is the systematic allocation of an asset's cost across its useful life — the span of years the business expects to get service from it. This is the matching principle doing exactly its job: the van helps earn revenue in each of those five years, so a fair slice of its cost belongs in each of those five years too. Lumping the whole 30,000 into year one would crush year one's profit and flatter years two through five, even though the van works just as hard in every one of them. Depreciation is how we keep each year honest.
The simplest way to slice the cost is straight-line depreciation: equal amounts every period. You need three numbers. The first is the asset's cost, 30,000. The second is its salvage value — what you honestly expect to sell or scrap it for at the end of its life; say 0 for a van you will run into the ground. The cost minus salvage value is the *depreciable amount*, the part that genuinely gets used up: 30,000. The third number is the useful life, 5 years. Divide depreciable amount by life and you get the annual charge.
Plug in the numbers and the arithmetic is gentle: (30,000 minus 0) divided by 5 equals 6,000 of depreciation per year. Change just one assumption and the charge moves with it — if you expected to sell the van for 5,000 at the end, only 25,000 ever gets used up, so the yearly figure drops to 5,000. Notice that only the part that actually wears away is spread across the years; the salvage value is the floor the asset is never depreciated below.
The entry, and the clever account it credits
Now the entry itself. At the end of each year you record a depreciation adjusting entry: debit Depreciation Expense 6,000, credit Accumulated Depreciation 6,000. The debit is intuitive — Depreciation Expense is an expense, expenses carry a debit normal balance, and this one reduces the year's profit by 6,000. The credit is where beginners pause. Why not just credit the Van account directly, the way using up prepaid insurance credited Prepaid Insurance? You could — but accountants deliberately choose not to, for a reason worth understanding.
The credit goes to [[accumulated-depreciation|accumulated depreciation]], a special creature called a *contra-asset*. An ordinary asset has a debit normal balance; a contra-asset has the opposite, a credit balance, and it lives right beneath the asset it offsets. Think of it as a running tally of how much of the van's cost has been used up so far. After year one it holds 6,000; after year two, 12,000; after three, 18,000 — it accumulates, exactly as its name promises. Crucially, the Van account itself never moves. It keeps showing the original 30,000, because that is a fact: that is what the company paid, the cost principle in action.
Why keep both numbers — the full cost above and the accumulated wear-and-tear below — instead of collapsing them into one? Because together they tell a richer story than a single net figure ever could. A reader who sees a van at cost 30,000 with accumulated depreciation of 24,000 instantly knows two things: the company paid 30,000 for it, and it is four-fifths of the way through its life and probably due for replacement soon. Squash that into a lone '6,000' and you have thrown away the asset's whole history. The contra-asset preserves it.
Book value: the number that quietly falls
The asset stays at 30,000 and accumulated depreciation climbs; the gap between them is what really shrinks. That gap has a name: [[book-value|book value]], also called the carrying amount. Book value equals cost minus accumulated depreciation, and it answers the question 'how much of this asset's cost has not yet been charged to expense?' At purchase, book value is the full 30,000. Each year it drops by 6,000 as another slice moves into the income statement, marching steadily toward the salvage value — here, zero.
Straight-line schedule (cost 30,000, salvage 0, life 5 yrs) Year Depr. expense Accumulated depr. Book value ----- ------------- ----------------- ---------- Start - - 30,000 1 6,000 6,000 24,000 2 6,000 12,000 18,000 3 6,000 18,000 12,000 4 6,000 24,000 6,000 5 6,000 30,000 0
An expense that costs no cash
Look back at the yearly entry and notice what is missing: cash. The only cash event was the original 30,000 cheque, years ago. Every depreciation entry afterwards is a pure bookkeeping move — debit an expense, credit a contra-asset — with nothing leaving the bank. This is the cleanest illustration in all of accounting that profit is not cash. A company can report 6,000 less profit this year purely because of depreciation while its bank balance does not budge by a cent. Depreciation lowers reported earnings without anyone reaching for the chequebook.
- Buy the asset: debit the asset (Van 30,000), credit Cash 30,000. This is an ordinary transaction, not an adjustment — cash genuinely moves, and the cost is capitalized, not expensed.
- Each period end, compute the charge: (cost minus salvage value) divided by useful life for straight-line. Here, 6,000 a year.
- Record the adjusting entry: debit Depreciation Expense 6,000, credit Accumulated Depreciation 6,000. No cash, ever.
- Read off book value: cost 30,000 minus accumulated depreciation, the figure that walks down toward salvage value over the asset's life.
Be honest about what depreciation does and does not promise. The useful life and salvage value are *estimates* made by people, not laws of physics — a van might last four years or seven, and reasonable accountants can disagree. That judgement is exactly why depreciation can be stretched or compressed to nudge profit, and why auditors look hard at the assumptions behind it. Depreciation makes the period-by-period picture far more truthful than dumping the whole cost into year one, but it is an allocation built on forecasts, not a measurement of reality. When the asset is finally sold or scrapped, a separate reckoning — its disposal — squares the book value against whatever cash actually changes hands, and that is a story for the next rung.