 hello in this lecture we will calculate depreciation using the units of production method at the end of this we will be able to calculate depreciation using the units of production method create the journal entry related to depreciation explain the effects of recording the journal entry related to depreciation on assets equity and net income so in the past we have calculated depreciation using the same information using the most common sense type of method that the first method that we would probably think of when allocating this process that being the straight line method so for example if we had our piece of equipment for 257.5 let's first think about the problem that we have and then how we can solve that problem so the problem is that if we just expense that 257.5 when we buy the equipment then it will greatly reduce net income at the time of purchase and that does not necessarily match in accordance with the accrual principle of matching the expense to the revenue it helped to generate for example it would make the net income for the year of purchase a lot lower because of that purchase and then the next year the income would most likely be higher because this expense for this purchase is not included in the following year although we are using the equipment in the following year so the idea then is that we need to be able to compare the income statement from year to year how can we do that how can we allocate this expense in an appropriate way that we would believe is more appropriate so that we can see a allocation of the expense and compare the income statement the first thought to do that would be well maybe we should get find the useful life to see how long we're going to use this piece of equipment and then divide the cost by the useful life allocated across the time frame and that therefore we would we would expense an equal amount throughout that time frame that would be the straight line method and an alternative method to that would be the double declining method that would be a method thinking that the first year should have a greater amount of depreciation than the later years so we would have a method that would basically front load the depreciation in the current years in the beginning years and have a less depreciation in the later years the next method that we will talk out here is the units of production the idea of the units of production method being that why are we using time at all as the measure we should be using the units of production meaning we should allocate not based on time we should allocate based on a better driver in terms of how we will know how much cost has been used so for example in a car instead of just depreciating over the time that we have had the car why don't we depreciate using mileage in that case so we'll depreciate not based on how old the car is we'll depreciate based on how many miles has been driven in a lot of ways people would think that that would be a more accurate way of depreciating so that's what we'll talk about here of systems such as that so in this case we got equipment purchased on January 1st costing 257.5 salvage value 20,000 remember what salvage value means that means that we can sell the equipment for the 20,000 at the end of its useful life now we still have the information it's going to be a four year useful life that information is somewhat irrelevant here but i want to keep it in there just to compare it to the prior methods that we have used it'll still fit into the four year period in this case so we can show that four year period comparison but really what we're going to estimate is not based on the time we're going to estimate on the units of production so in this case we believe that you know this thing is going to produce 475,000 units so you can imagine that if we got a printer or something like that a very expensive printer in this case that on the box it says that i'm going to this printer will produce 475,000 pages that would be the life of the printer in terms of production of what it will produce so rather than taking the four year as the driving factor to allocate depreciation we want to take the number of produced units in order to drive the allocation in that example being pages to produce if it was some type of printer so we will then allocate a cost per page or per unit in this case that calculation would be the cost being the same cost as all of our other examples 257.5 we're going to subtract from that the salvage value why because that's the floor remember that we're not going to depreciate this thing to zero even after we've used it like if it's a printer even after it's no longer usable and all the rollers are gone and we can't use it we still think that we can expense this thing for 20,000 therefore we have the floor of 20,000 rather than zero that's the salvage value that means that over the life the life not necessarily being four years in this case it will happen to work out the four years because we set it up that way but the life being 475,000 pages will at the end of that will have accumulated depreciation of 237.5 what does that mean it means that if we calculate the book value at the end of that then we'll have a cost of 257.5 less the accumulated depreciation of 237.5 which will leave a value on the books book value of 20,000 equivalent to the salvage value so once we have the number that we're going to depreciate over the useful life then we divide that not by the number of years as in prior examples but by the number of units to be produced if we're talking about pages on a printer the number of pages that means that each page theoretically is worth 0.5 50 cents basically per page so now we're going to count the number of pages that are printed each year and multiply that times the rate we got 50 cents per page that's how we're going to get our depreciation note the extra work we need here we know do we need to know some extra facts that we did not need to know before one how many pages is it going to produce that's got to be determined in some way similarly to us having to determine the number of years and two we need to count the number of pages each year which could be a daunting task depending on how automated the process is so now when we calculate the depreciation for each year the problem is going to have to give us one more piece of information that that piece of information being how many units did we produce in this case if we're talking about a printer how many pages did we produce in that year once we have that it becomes a fairly simple calculation to calculate the depreciation meaning if they tell us we printed 220 000 units we're going to take the number of units that were produced multiply times the rate that we just came up with we said 50 cents per page therefore if we multiply that out then 220 000 times 50 cents gives us the depreciation of 110 000 so if we were then to do our calculation in terms of the book value in terms of our table we say the depreciation for year one is the 110 000 we just calculated how do we calculate the book value we take the cost the 257 5 less the accumulated depreciation what is accumulated depreciation it's last year's accumulated depreciation plus the current year's depreciation expense or the accumulation of all depreciation over the life up until this time period which is just the current year therefore it's the 110 000 and if we subtract that out then we have a book value of 147 5 so if we take a look at the context of this in terms of other accounts the journal entry remember that we looked at the journal entry in the adjusting journal entry process we just did not look at how to calculate it so now we've done the calculation but let's take a step back and remember that this is an adjusting journal entry that we are recording here if we take a look at our list of accounts we have assets in this case in green both in this side is before the transaction is being recorded so we've got the assets their debits represented by the fact that they do not have brackets then we have our equipment that is on the books at the cost that we pay for it nothing is an accumulated depreciation until we record this transaction we've got the liabilities in brackets because they're credits so credits are in brackets the capital count the equity section revenue is a credit balance so it's in brackets and the only expense that we're going to look at at this time will be the depreciation expense because we want to isolate that expense and see the effect of that expense on the net income so before we record the journal entry net income is just the 100,000 we're assuming we earned 100,000 in year one before this adjusting process in the adjusting process we have one income statement account generally all pretty much all the time one balance sheet account the income statement account will of course be depreciation expense income statement expense accounts only have debit balances and they generally only go up so therefore we're going to debit it making it go up and the other account that we're going to select is accumulated depreciation which I've abbreviated here and it will of course be a credit if we debit depreciation expense therefore the transaction looks like this debit depreciation expense credit accumulated depreciation if we post that then the depreciation expense is here goes from zero up by 110 in the debit direction to the 110 what happens to net income it was at 100,000 just the 100 less the zero minus the 110 means that we are actually at a loss now the non-bracket numbers means the debits are winning means the expenses are winning over the revenue therefore we have a loss of 10,000 in this case the depreciation expense is going to go from zero up in the credit direction to 110 and note that that is a contra asset account meaning it's green because it's in the asset section but it has a negative or a credit balance so that is contra to normal assets you might ask well why does it have a credit balance and the reason is that we do not want to write down the equipment directly because we're trying to tell our reader hey this is just an estimate on in contrast if it was something like supplies when we write down supplies that's because we actually see a physical deterioration in supplies i can go to supplies and count it and see that it has physically gone down the number of units has gone down on the other hand if we take a look at the equipment if it's a printer in this case there's still only one giant printer that cost the 257.5 right and it's not like the printer went away we don't have less printers we can't count the number of units therefore we're trying to tell our reader hey we're breaking the t account between a t account to now a seven and an r right we broke the t up and the debit side is up here the credit side is down here and that's a you know rough estimate of this and therefore we have that's what results in the contra asset account if we take the 257.5 less the accumulated depreciation that will of course be the book value of 147.5 year two very similar calculation very easy until we get to the final year the final year will change so year two same thing we're just going to say units produced in year two they're going to have to give us that number in the problem and we'll just multiply that times our rate for the year that we calculated first off once we have that rate very easy to calculate this and then if we multiply that out we got 62 three in this case that's the depreciation for year two if we look at that in terms of a table here's where we were in year one if we look at the book value and the depreciation in year two and compare it we can see that now the depreciation went down that will not necessarily be the case your two could be higher than year one we don't really know what's going to happen from year to year because we're really basing it on the the output of the machine which we do think is more accurate we could make the assumption that the first year will be a better output than the second year making the assumption that the machine is more productive in the first years than in later years that would be a reasonable assumption if this was what actually happened these would back up that reasonable assumption and then if we take a look at the book value then we have the cost less accumulated depreciation how do we calculate accumulated depreciation well it could be the last year's accumulated depreciation plus the current year's depreciation expense will give us this 172 three or we can add up the depreciation expense throughout the life of the equipment to this point being 110 000 plus the 62 3 would also give the 172 3 so the cost less the accumulated depreciation gives us the book value of 85 200 so if we look at this in terms of the the transaction then in terms of the accounts this is where we start off in the adjusting process before this adjusting entry at the end of year two rather than year one we can see that we left off after year one and before recording this in year two adjusting entry we have the cost at 257 five less the accumulated depreciation book value 147 five we have nothing in depreciation expense why because that depreciation expense was was carried into or closed out to the equity section in this case the capital account so note that the accumulated depreciation is a permanent account it still has the 110 in it that we put in there in year one the depreciation expense does not still have the 110 in it because it is a temporary account which then closed out to the capital we still do have the 100 000 in revenue but it's not the same 100 000 the assumption is that year two we earned another 100 000 and the idea is that we want to have a model that we have the same amount of earnings in year and one in year two so that we can then see the effect of depreciation on that net income if that was the case holding all else equal so the depreciation journal entry then would be the same we're going to debit depreciation expense we're going to credit accumulated depreciation for the amount calculated that amount being the 62 300 so here's our journal entry here's the transaction that what it will look like when we post this out depreciation expense is going to go from zero up in the debit direction to 62 3 what happens to net income it was at that 100 000 from the revenue less the depreciation that we have recorded on the income statement which is an expense bringing the net income down to 37 700 what happens to accumulated depreciation it goes up from 110 up in the credit direction a same thing makes it go up a credit and a credit makes the credit go up in the credit direction to 172 3 the book value then is the cost 257 5 debit less the 172 3 credit giving us the book value of 85 2 which we see in the table year three very similar transaction once again this is not the final year it will change in the final year but in year three we have the same thing we're going to count the number of pages that were produced in that year then multiply that times the rate that we determined being 50 percent 50 cents per page remember that the problem will have to give you this number it's going to have to tell you how many pages were produced in real life we would have to track that the equipment that we got in this case the printer would have to somehow track the number of pages that have been printed which is more than doable in today's technology and so that would give us the 60 000 nine in year three depreciation expense in this case so if we look at where we had before and now we add year three we can see that now we have 60 000 nine again it's a little bit less than the prior years not it's extreme a change from year one and once again it should follow the actual use of the printer in this case or whatever the machinery is and the printing use could go up and down for reason for reasons other than just the level of production that it is able to do our level of need may go up and down and once again just like driving a car if we if we don't need to drive it then you would think that it should depreciate less we should be able to hold it on to it longer if we still take care of it and it should be in better condition in that case and so that's why this is generally thought of as a method that's probably closer to a reality in terms of an estimate of value so we can see that the cost is still the same we're going to calculate the book value by the cost less the accumulated depreciation what is the accumulated depreciation it's last year's accumulated depreciation the 1723 plus the current year depreciation expense the 60 000 nine will give us the 233 200 current year accumulated depreciation we can also calculate it as adding up the depreciation expense throughout the three years being the 110 000 plus the 62 3 plus the 60 000 nine should also give us the 233 2 we can see that the 257 5 of cost less the accumulated depreciation 233 2 will give us the book value at this point of 24 300 if we look at the journal entry then remember where we're starting we're in the adjusting process at this point before recording this adjusting entry of depreciation expense so at the beginning of year three before this adjusting entry we have the equipment on the books at 257 5 same thing and we have the accumulated depreciation at 272 3 that's where we left off at the end of year two we can see that the depreciation expense is zero why is it zero because the amount that we put in there last year has now closed out to the capital account it's closed out to the capital account is now zero we can see that the revenue account is at 100 000 that's not the same 100 000 we're assuming we earned the exact same amount of money in year three as we did in prior years in order to hold all else equal so that we can see the effect of this journal entry over multiple years so if we see the journal entry then we're going to debit depreciation expense once again credit accumulated depreciation once again for the amount calculated in year three being 60 900 if we look at the posting of that then the depreciation is going to go from zero up by 60 900 what is that due to net income it brings the 100 000 down to 39 100 once again this is income not a loss the brackets represent a credit not a negative number so revenue is beating expenses by 39 100 what happens to accumulated depreciation we have a contra asset account an asset which has a no an abnormal credit balance of 172 3 goes up in the credit direction because we did the same thing to it to 233 200 what's the book value now if we look at this 257 five less the 233 200 the equipment less the accumulated depreciation given the 24 300 now we're going to do this again this happens to be the final year and in this problem of course we knew that because it said it's a four-year property but once again this this information we don't really even need to know that for units of production we but we do for this problem because we know it's going to be in comparison to the other problems because we want to compare the same time frame but in reality we may not even know how many years we would estimate it most likely but we're really going by how many units were produced so what we're looking for in the final year is that if we calculate the book value after recording depreciation and the book value is less than the salvage value remember that we need to stop there similar to the double declining balance method so we can see this most easily if there was no salvage value so for example obviously if there was no salvage value and we depreciated at 50 cents per page and it happened to be that we printed more pages than we estimated to print we pen more pages than the 475 thousand pages then if we keep on recording that 50 percent a page we will end up with a book value below zero at some point and that's not feasible we cannot have a printer that is worth negative money that doesn't make any sense the idea of course is to allocate the cost of 475 over the life of the printer if we keep printing after we've completely allocated the cost the estimate is wrong in most cases that's not a problem because the estimate will be wrong maybe by something that we believe is in material so even though we're still using the printer it's going to have a value of zero meaning the cost less the accumulated depreciation if there was no salvage value would be at zero and we just stop and we say yep we're still using it but it's at zero value we think it's on its last way if it's a substantial difference that really affects the financial statements we may have to make the adjustment or adjust the time frame at that point that we determined that but for the most part we we're going to go with the estimate and usually we're just not going we're just going to stop depreciation at that point if there's a salvage value that remember means that that's the value that we believe we can scrap the equipment for even after it's stopped being useful then instead of the floor being zero the floor is the salvage value so in year four that happened to be the case if we took the 15 to for example multiplied at times 50 percent and then recorded the depreciation we would come up to a book value less than 20,000 so I'm not going to do that practice but just you know take my word for it it's the final year it would not work therefore we're going to do the thing that really kind of disturbs people sometimes when we want the math to work out perfectly and be really nice working it doesn't work out perfectly the math unless we happen to produce exactly 475,000 pages and then the printer just died that's the only time that the math would work out perfectly and obviously that's not going to happen because this is just an estimate so at the end of the final year what we will have to do is say okay we're just going to do whatever we need to do to plug it so that the book value ends up at the 20,000 salvage value now remember once again if you're doing a multiple choice question probably not going to be asked to do this calculation in the final year because it would just be a lot of work for one multiple choice question on something like an exam but you do want to be aware of that because it is it is relevant and you do need to know that that final year is going to be kind of a plug type year to make it work in both the double declining balance and the units of production method so how can we do that we can take the cost and subtract the salvage value and that means that we need to depreciate the 237.5 over the useful life so that at the end when we're totally done calculating depreciation meaning we want the accumulated depreciation to be 237.5 why because then if we calculate the book value the cost less the accumulated depreciation of 237.5 will leave us with the salvage value of 20,000 which will be what we want because that's what we think the thing will be worth after we stopped using it and we sell it for that amount or scrap it for that amount so then we're going to subtract out the accumulated depreciation that we have accumulated to date so up through year three in this case we've already have an accumulated depreciation before recording depreciation for year four of 233.2 therefore we need another 4200 in year four so that we stop exactly at the point at which the book value will be calculated to be 20,000 let me show you what I mean on the table here's where we left off last night time notice the book value last time was 24.3 and this time we need to we need to depreciate that 4003 why because that will bring the accumulated depreciation up to 237.5 how do we calculate accumulated depreciation it's prior year's accumulated depreciation of this 233.2 plus the current year's depreciation expense 4003 will give us this 237.5 or we can say it's the sum of all the depreciation expense up until this point in time being year one 110,000 year two 62.3 plus year three 60,009 plus year four of 4003 will also give us the 237.5 if we subtract out the cost less the accumulated depreciation the 257.5 less the 237.5 we get the 20,000 and that equals the salvage value salvage value being the floor so now if we look at posting this final year then we can take a look at our trial balance and notice once again we are in year four before we do the adjusting entry process being recording the depreciation expense we have the activity being the equipment on the books at 257.5 less the accumulated depreciation of 233.2 and that will give us a book value of the 24.3 which is where we left off at the end of year three in terms of the equipment and the estimated depreciation account in terms of the depreciation expense we are at zero why because all prior year depreciation expense that we have recorded to this account have been closed out through the closing process to the equity account in this case being the capital account we also have the 100,000 here being revenue this is not the same revenue as we have had in the last three years it's assuming that we have been very consistent and we earned the same amount of revenue in year four and the idea being that we want to have everything constant and so we're going to assume that we have earned the exact amount of revenue have the expense only be depreciation expense and see what the effect then is on the net income as we go so in this case we're going to do the same journal entry and that will be a debit to depreciation expense a credit to accumulated depreciation this is an adjusting journal entry this is a journal entry we do at the end of the month or year and the amount will be for the depreciation that we calculated being the 4,300 if we record that depreciation expense goes from zero up in the debit direction to 4,300 the effect on net income is the 100,000 revenue that we earned in year four less this expense of 4,300 will give us the 957 the 100 minus the 4,300 the 957 on the accumulated depreciation it goes from a credit balance up in the credit direction because a credit and a credit is the same thing making it go up to the 237.5 we are now left with the 257.5 less the credit of 237.5 giving us 20,000 on the books we're going to leave it there that's where it's leaving because that is equivalent to the salvage value which is what we believe that we can expense the equipment for so what happens in year four we don't post any depreciation expense does that mean that we just stopped using the printer at that time and we don't print any more pages well not if it's still working but we're not going to record a cost less than what we think that we can sell the machine for and clearly of course this would make a lot of more sense to drive the point home is that if we recorded it to zero then we could not record anymore from that we can't have a credit in this account larger than the cost that we bought the machine for so the idea is that we are allocating the cost over the useful life if we allocated incorrectly then it's not the cost that was wrong it's the allocation of the useful life that was wrong so now let's take a look at a comparison between the three methods you obviously we're not doing these three methods at the same time we're going to pick one of these methods in order to allocate the cost and so we had the straight line we've got the double declining and we have the units of production remember what happens under the straight line is that we have an even amount of depreciation over the four years this would make a lot of sense to most people this would be the first thing that most people would start to think of if they were confronted with this problem of trying to find comparability and what happens to the book value it goes down at a constant rate if we look at that in terms of what happens to net income notice that if we earned the exact same amount each year and held all else else equal being the only expense being depreciation expense then we would have an an even distribution that would make a lot of sense and note what the assumption is though the assumption is that the the machine was used completely the same over the four year time period and because we made the same amount of revenue maybe that's the case because we had the same amount of production but at the same time it could be thought that the depreciation of the machine should be higher in the first year than the lighter years one because it's it's more productive in the first year and there could be other factors meaning that the value of the machine goes down just in terms of newer things coming out and stuff like that and that would be an argument for the double declining method which would be that we're going to front load the depreciation expense remember over the four year time period the depreciation will be the same but now you can see that there's a lot more in year one than in year four we can see that in terms of the book value what's the account on the book value it goes down at a much higher rate in the beginning years than the later years we end up in the same spot meaning we're ending up at 20 000 at the end of the period in this case four years we are in the same spot so year five won't look any different under the two methods so the question could be a lot of people might ask is why does it matter over the long run it's okay the short run right as the short run matter well there's a pretty substantial difference in the short run so it could make a substantial difference in the short run when we're trying to think about the comparability because really what we want to do is see in terms of accounting which one of these two allows us with the best to get the best comparability note that what happens to net income in this method is we actually end up with a loss in year one where we had income in year one under the straight line and then we have income here versus income here now the income is higher in year three and the idea under the accounting method from a management standpoint is which one of these two is most reflective did we really do worse in year one than in year four or is it fair for us to allocate more in year one than in year four that those are the questions from a tax standpoint note that if we had our our preference we'd probably want to depreciate more in year one than in year four why because that will lower our tax bill and we'd rather have the tax bill lower today than lower tomorrow because I want to pay less taxes to bit today because of the time value of money so it it really depends on what our incentives are in terms of which is most important the major incentive I want to have in our heads when we think about accounting is which is more accurate for us to make better decisions and then of course the unit of production method the idea usually is that the unit of production method will be more accurate because we're using a method that's not just based on time it's based on usage so when you ask the question that should we depreciate more in year one than year four the answer that might test that method better would be well why don't we do it by testing what it produces rather than just time and that will tell us whether the machine is making more output in year one than year four if we do that in this example we note that it does in year one we recorded depreciation based on its performance and it performed more in year one than it did in later years of course year four we had to plug in there because we're still using it and it produced more than we estimated but the assumption here would be that it that it was true that it performed far better in year one than in later years and that would kind of support the double declining balance method here we could see the effect on net income the effect on net income in this case happens to be kind of in between the straight line double declining doesn't necessarily have to be that way that's just kind of the way it's worked out in this case so we are now able to calculate depreciation using the units of production method create the journal entry related to depreciation and explain the effects of the recording the journal entry related to depreciation on assets equity and net income