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.
Straight Line Depreciation
Play a video:
Was this helpful?
Alright so let's see how we're going to calculate our depreciation expense per period in the straight line method. So remember we've got our three variables cost useful life and residual value. We're gonna be dealing with this in all the different depreciation methods. Okay so let's see how it works here, notice we've got cost minus residual value in our numerator. So what we call this cost minus residual value. Well this is called the depreciate ble base. Okay appreciable base because this is what we are going to depreciate. Think about it. We've got the cost, what we paid for it minus the residual value. What's gonna what we think it's worth at the end? So everything in between the cost minus the residual value. Well that's what we're gonna depreciate. So after we do this depreciation we're gonna be left with the residual value. Okay so cost minus residual value divided by the useful life and pretty much all the time. We're gonna be talking about years of of useful life. Okay so this is going to tell us the depreciation expense per period. Okay so the nice thing about the nice thing about um straight line depreciation, that makes it so easy is that every year every period we're gonna have the same amount of depreciation expense. So that's why it's a little easier. Let's go ahead and jump into an example. So I can show you what I mean on january 1st. Let me keep that on the screen on january 1st year, one, johnson and johnson and johnson company purchased a delivery truck for $42,000 the company estimated a useful life of five years and a residual value of $2000. What would be the entry to record depreciation when preparing the december 31st year one? So notice it's been a year, right? We bought it on january 1st announced december 31st. So the entry to record depreciation and the netbook value. So we'll get to net book value in a minute. But let's start, let's start here with our depreciation expense per year. And how much depreciation we're gonna take the first year. So let's use our formula. We've got cost minus residual value over useful life. So the depreciation expense, I'll put D. E. P. Expense per year. Which also means the first year. What's the depreciation expense? Well it's gonna be the same amount. So depreciation expense per year. Well that's gonna be our cost of 42,000 minus a residual value of 2000. Right? That's what they told us in the problem. 42,000 minus 2000. And what's our useful life? five years. Right? So we think it's gonna be useful for five years. So let's go ahead and find out our depreciation per year. So notice 42,000 -2000. That's 40,000, right? That is our depreciate ble base, as we said above. So the total amount of depreciation. We're going to take over the five years is the 40,000 that depreciate ble base. So we divide it by five and we're gonna get 8000 per year in depreciation, right? So that's why this is so simple. We've already got our depreciation for every year for the next five years. Alright so our entry our journal entry, every time we record depreciation expense we're gonna make this entry no matter what um no matter what method we're using straight line or the other methods we're gonna deal with later. We're going to debit depreciation expense for the amount 8000 here. And it's a debit right? Because it's an expense. So we debit our expenses and what's going to be our credit are credit is accumulated depreciation. So remember that this accumulated depreciation, accumulated depreciation. And I'm gonna just put D. E. P. Accumulated depreciation is a contra asset, right? So this is lowering that net book value. Right? So now let's calculate net book value. Remember we have our asset of the truck which has a debit balance and then the accumulated depreciation is going to have a credit balance lowering this netbook value. So this netbook value, we call it N. B. V. For netbook value is our cost minus accumulated depreciation. Okay that's how we calculate our net book value. And this netbook value. That's generally what we show on our balance sheet on our financial statement will show the net value of the truck. Okay so let's go ahead and calculate this. So after one year after we've depreciated it for one year. Well our cost was 42,000 minus accumulated depreciation. Well, it's only been one year. So we've only accumulated one year of depreciation, which is 8000. And Our Net Book Value is the 42000 -8000. We've got a 34,000 net book value. Okay, so just to reiterate how we might see this on a balance sheet here, um I'm trying to get out of the way so you can see behind me, doesn't seem to be working. So I'll try and stay out of the way and I'll do it here on the side. All right. So what we've got, we would show our assets, just like we do on any balance sheet, right? We would have our cash, we would have our accounts receivable inventory, whatever assets we have, right? And would show their balance, and then we might get to our fixed assets and we'd say something like truck, and we would show 42,000 right? The cost of the truck. And then we'd say something like less accumulated depreciation, which I'm just gonna say a prayer a slash D for accumulated depreciation. And we would say less accumulated depreciation, which at this point is 8000 and then we would show the netbook value here of 34,000 troops. Make it fit on the screen there. I'm balancing between staying out of the way, since I can't get out of the way for some reason right now. Alright, So we would show the Netbook value just alongside all of our assets there. So notice we're showing the historical cost, we're leaving the truck the value of the truck that we paid for at its historical cost, but then we lower it with this accumulated depreciation over its life. Okay, so let's pause here, and on the next page, we're gonna continue this example and kind of follow the whole life of this asset. Alright, let's go ahead and do that now.
Straight Line Method Through Life of Asset
Play a video:
Was this helpful?
Alright, so let's continue with that example. And let's follow this truck through its entire useful life. Alright, so I've summarized our data here, we've got the cost of the truck, the residual value and the estimated useful life. Okay, so those are three main numbers that we need to know to do our depreciation entries. And let's go ahead and start here on january 1st year one, we purchased the truck at this point, there's no depreciation, right? We just bought it, no time has passed, no depreciation expense, no accumulated depreciation. Right? So our net book value. Well remember net book value is the cost minus accumulated depreciation. So all it is is just the cost at this point. But I'm gonna write out the formula, so cost minus accumulated depreciation of zero. Well, that gets us to our net book value of 42,000, right? So if right now we are going to show a balance sheet, it would show a value of 42,000 for the truck. Cool. So now time has started to pass, a year has passed, just like just like in our example above. And now we have depreciation expense, right? We calculated it as 8000 per year and this is what's so nice, it's gonna be 8000 every year here for the straight line depreciation method, right? So now our accumulated depreciation it was zero And now we added 8000 to it for the first year and we're at 8000 total accumulated depreciation. So our net book value is gonna start decreasing, right? We've started taking depreciation And now our net book value is 34,000, just like we saw in the example above. Cool, so now let's keep going through the rest of the useful life the next four years to get through the entire five year useful life. So year to another 8000 depreciation expense. And now our accumulated depreciation is the 8000 from last year plus another 8000 gets us to a total 16,000 and accumulated depreciation. And that's gonna keep lowering our net book value, 42000 -16000. That's going to equal 26,000 here. Right? So let's go another year. Guess what? The depreciation expense is 8000 again, right? Straight line method keeps it easy like that. So now we've got 16,000 previous accumulated depreciation And now we're gonna add another 8000 to it. Right? So now notice 24,000. This makes sense, right? It's been three years and 8000 times three is 24,000. We've taken three years of depreciation. So accumulated depreciation is 24,000, cost minus our accumulated depreciation of 24,000. Well, that gets us to our net book value of 18,000. So when we show our year three balance sheet, it's gonna show the truck with a netbook value of 18,000. So let's keep going another 8000 in year four for depreciation expense and that brings our accumulated depreciation Up to 32,000 and our net book value? 42,000 in cost minus 32,000 and accumulated, gets us to 10,000 as under our net book value. And finally year five. Remember we had a five year useful life and we're finally in that fifth year. So we take our last 8000 of depreciation expense and check this part out, 32,000 plus 8000. Our accumulated depreciation is 40,000. Remember when I talked about the depreciation base? Our depreciation base was the numerator in our equation, the cost minus residual value. So our cost of 42,000 minus our residual value of 2000 is 40,000. Right? And that after the five years we we've taken all of that depreciation base over the five year life? So here are total accumulated depreciation that we've taken over. The life is 40,000. So it all works out here. And guess what's left in our net book value. The 42,000 minus the 40,000 in depreciation accumulated depreciation Gets us to our residual value of 2000. So now all that's left is the residual value. What we expected it to be worth at the end of its useful life? Now, I've got a interesting question, what happens if the truck isn't isn't done being used? Right? We estimated it would last five years. Remember? It's just an estimate? Well what if it lasts six years? What if we go on into the six years? How much depreciation expense are we gonna take in year six? Do you think it's the 2000 and residual value? No, we actually don't take any depreciation. There's no depreciation in year six. We've already fully depreciated this asset all the way to its residual value. Okay, so there's gonna be no more depreciation. Even if we go into year seven and year eight, we're not gonna take any more depreciation are accumulated. Depreciation is going to stay at the 40,000 total and our net book value will stay at 2000. Remember? This is what we're expecting to be able to sell it, sell it for when we're done using it. So once we finally sell it we'll we'll have entries to deal with that and we'll talk about that in a later lesson. But for now I just wanted to point out that once we fully depreciate the asset, we don't keep depreciating, there's no more 8000. We couldn't take another 8000 in year six, we don't get rid of the residual value. That's what we expect it to be worth still. So that's what we want to leave it at that value on on our balance sheet. Cool. So now that you kind of see the full effect of the straight line depreciation method? Why don't you guys try some practice problems and work with this formula yourself? Alright, let's do that. Now
ABC Company purchased a new machine on January 1, Year 1 for $44,000. The company expects the machine to last ten years. The company thinks it could sell the scrap metal from the machine for $4,000 at the end of its useful life. If the company uses the straight-line method for depreciation, what will be the net book value of the machine on December 31, Year 4?
DBQ Company purchased a machine on January 1, Year 1 for $60,000. The company estimated a five year useful life and $8,000 residual value. If the company uses the straight-line method for depreciation, what will be the amount of accumulated depreciation on December 31, Year 2?