Introduction to Depreciation

Brian Krogol
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So let's start our discussion of depreciation methods with the most common one, The straight line method. Alright, before we dive into the different methods, the first thing I want to do is talk about depreciation on a high level things that relate to all the different methods. So remember that depreciation, what it's gonna do is it's gonna break up the cost of some high value items, some fixed asset that we're gonna buy and use for multiple years. What we're gonna break up that cost that we spent up front, we're gonna break it up over the useful life of the asset. Alright, so we're gonna be using it, remember for many years and why do we use depreciation? We'll gap requires it because it's an example of the matching principle. Okay, remember that the matching principle, we're gonna be earning revenues and when we earn those revenues, Well, we want to match the expenses that helped us earn those revenues. Right? Okay. So let's see in a simple example here, why depreciation expense is an example of the matching principle. So we've got two boxes here. This red box up here salmon colored, I guess this is gonna be the bad way. And this is the good way down here in green, the good depreciation expense way and the bad way is up top, which is more of like the cash basis kind of way. Alright, so let's see why we don't want to do it from this cash basis perspective. So let's think about an airline company like american airlines or something and they purchased an airplane for $20 million. So in the bad way, they're not gonna capitalize the asset and depreciate it? No, they're gonna say, oh, we spent $20 million on an airplane. That's airplane expense. Alright, write it off the airplane expense. Everybody and they're gonna do airplane expense For $20 million dollars in the first year, right? When they bought the airplane And that they paid for it with cash, right? They paid for it with 20 million in cash. So there we go, airplane expense of 20 million. But notice it's gonna generate revenue for 20 years, right from year 1-20. It's gonna be generating revenue of $5 million dollars per year. So we would be making an entry from year every year. From year one to year 20. We would be getting cash, right? We would be getting cash from our customers of five million and we'd credit revenue. Right? This revenue is going to our income statement, we're getting five million of revenue every year. But notice in year one, okay, we matched some of the expense. We got some revenue and we've got the airplane expense in year one, right? So this was happening in year one over here and this is happening in year one. Okay, we're matching a little bit, but what about in year two? We already wrote off the entire airplane in year one and year two. There's just revenue. Year three, there's just revenue. Year four revenue. So there's no matching there, right? How did we earn that revenue? Oh, with that airplane, what airplane? You already expensed it? There's no, there's no track of how much you spend on this airplane and how much it's costing you. Right? So this doesn't really match our revenues with our expenses very well at all. So let's look at the good way when we are using depreciation expense. So what we do with these fixed assets, like we learned in our cost lesson is we're gonna capitalize them, we're gonna put them on our balance sheet as an asset, right? When we capitalize something, it's making it an asset on our balance sheet. So the same thing we're gonna purchase an airplane for $20 million but instead of going to airplane expense, well now it'll go to, you know, equipment or something like that. Some sort of, Um, fixed asset account that signifies that we have these airplanes right? $20 million 20 million and we'll create cash. We still paid for it with cash. So notice at this point we've taken no revenue. We've taken no expense. Right. All we did was purchase an airplane and now we have an asset of an airplane. So now throughout years one through 20 what we're gonna do is we're gonna generate our revenue, but we're also gonna take our expenses every year to match those revenues. So as we've done before, we've, we've probably messed around with the straight line method of depreciation when we've talked about it in the past. So let's do a really simple example of it here. We've got a 20 million airplane that's gonna generate revenue for 20 years. So it's got a 20 year useful life. So over here in the corner, It's a $20 million 20 million. I mean, 20 million year useful life. That's crazy. Uh a 20 year useful life. So $20 million 20 years, that comes out to one million per year, right? one million per year. See there, that on the edge there. So that's gonna be our depreciation expense every year, notice we're breaking up that upfront cost of $20 million 20 years. Now there's different ways to calculate the depreciation, and we're gonna learn all those methods, but this is the simplest one and it's the one we're going to focus on in this video. So we'll start here and notice That we've got this one million per year. So we're still generating revenue, right? And the revenue is five million per year. So we're still getting that cash of five million, our revenue of five million. But now we're also gonna take a related expense, our depreciation expense. So that's gonna be a debit here depreciation expense for one million. And then what's the other part, remember we have that contra asset, the contra asset to depreciation expense. It's the accumulated depreciation accumulated depreciation. And I'll just put D. E. P. For depreciation. So that accumulated depreciation, it's related to this equipment, right? And it's a contra asset. So it goes up with credits and notice what happens every year. We're accumulating another one million of depreciation. And it's gonna keep lowering the value of that asset, right? So we've got our equipment over here for 20 million and the accumulated depreciation with the credits, that's gonna be lowering the value because we've got debits in the equipment and credits in the accumulated depreciation, which will be lowering the value. But notice with the matching principle, what we got here, we have revenues of five million every year and we're matching it with depreciation expense. So we're matching the expense every year of using this airplane with the revenue that we're earning every year. That's way different than we did in the bad example, right? Where we're getting revenue every year, but we only had the expense in the first year. Cool. So this is why we use depreciation expense is because it helps us match our revenues with our expenses. And it makes it makes a lot more sense of how we earn those revenues. Cool. So let's talk a little bit more about depreciation in general before we get to our method, the straight line method that we're going to talk about in this unit. So the first thing about depreciation expense. And I'm gonna leave this green on the screen up here. Uh, the depreciation expense is a non cash expense notice when we took our depreciation expense here, we didn't pay for it with cash, right? We had already paid the cash up front. So why is this important that it's a non cash expense? Well, it's gonna make more sense once we get to the statement of cash flows and we're calculating our cash flows from operations. Well, this, this depreciation expense that we have every year. Well, we already paid for it up front. So we're not taking out more cash to pay for depreciation. Okay, So that's something important to note that when we're taking depreciation expense, it's not like we're paying another million dollars for this airplane. No, no, no. We already paid for it up front and now we're just taking that cost and breaking it up over the useful life. Okay. And one more thing is that when we're taking depreciation expense and we're lowering the value of this airplane over time. Well, that doesn't necessarily tell us what the airplane's worth, right? We're just breaking it up in this consistent method that we've chosen, but it doesn't necessarily say that that's gonna be the market value of the asset. Okay, so our book value, the value on the books. So what we paid for the asset minus all of the accumulated depreciation we've taken so far. That might not exactly be what the asset is worth, maybe that airplane after five years and we've depreciated it for five years. Maybe it's worth more than we have on our books. Maybe it's worth less than we have on our books. That doesn't really matter until we try and sell that asset. Okay, so the market value and the book value, those are two totally different topics. Remember that the book value we're keeping at our historical cost. Okay. We're not gonna be adjusting it to that market value. So when we start calculating depreciation in all of our methods, we're gonna be dealing with three important, uh, factors here. Okay. The first is the initial cost of the asset, the initial cost of the asset. And we learned how to make the, how to calculate the initial cost of the asset in our initial cost video when we were calculating the cost of land, land improvements, buildings and equipment, that's where we talked about calculating what the initial cost is. Now, once we started doing depreciation problems, it's not gonna be as complicated as we did in that video. And these problems, it's usually gonna be, they're just gonna tell you the number, hey, this asset cost us $100,000. This asset cost us a million dollars. Right? They're not gonna have all those taxes and all those crazy things. We were talking about in that lesson. It's not gonna come up as it does in, in this, in when we do depreciation problems. Okay, so the initial cost is usually just gonna be given to you in these problems. Okay. So that's the first thing we need to know to calculate depreciation. The second thing is the useful life of the asset. So we've talked about useful life, how long is it going to be? Um how long is the company using the asset to help generate revenue? Right. So how long is the company gonna be able to use the asset to help generate revenue? Well, that's the useful life. Okay. And last is the residual value. So the residual value? Well, that's how much the company expects the asset to be worth at the end of its useful life. Okay. So how long the company is going to be using the asset to generate revenue and how long it's going to expect the asset to be worth at the end of its useful life? Well, these two things notice, I've got a bracket. These two things have to be estimated. How long will that airplane actually last. American Airlines. We can't totally be sure they estimated that it's gonna last 20 years. Well, maybe it's going to last 25 years. Maybe it'll burn out after 15 years because it wasn't made by the best mechanics. Who knows this has to be an estimate and it's gonna be the best guess of the company of how long it's going to last us as well as the residual value. That's going to be an estimate as well. You can't for sure know how much you're going to be able to sell it for at the end of its useful life, right? You can estimate what it's gonna be worth, but it could be worth more or less than that at the end of its useful life. So it's going to take some estimating to do these depreciation calculations. One more thing about residual value, it has other names. Sometimes it's called salvage value, scrap value value at the end of its life, you're gonna be able to tell what what what they're talking about when they're talking about the residual value. That's always gonna be what it's worth after you're done using it. Okay? So now that we were familiar with a lot of the high level concepts about depreciation, why don't we pause and then we'll go into our first depreciation method, the straight line method, and we'll do an example there. Alright, let's pause now.