 Hello in this lecture we'll talk about calculating depreciation using the straight line method. We will be able to calculate depreciation using the straight line method, create journal entry related to depreciation, explain the effect of recording the journal entry related to depreciation on assets equity net income. So in the past we have discussed talking about the recording of depreciation, meaning how do we record the journal entry for depreciation. We have not yet looked at how to calculate that depreciation in a defined way. Now we're going to talk about the calculation of depreciation but we always want to keep in mind that adjusting entry of what depreciation is. At the end of the day it's going to be reducing the cost of the equipment and recording the expense over the useful life. So keep the bigger picture in mind as we drill down into the the details of the calculation in this case. We're going to start off with the straight line method which if you were to ask someone how to solve this type of problem this would be the first method that would probably come to most people's mind. It's very common, sensical, and makes sense. So let's see what we have here. In this case we have purchase of equipment on January 1st costing $257,500, salvage value $20,000, useful life for years. First question then is the problem is this. If we expense that $257,500 in the year of purchase it will bring down net income and that could distort our net income when we compare year over year because we would have a reduction of this large purchase which hasn't been consumed yet, it hasn't been used. So in accordance with the matching principle we need to allocate that amount over the useful life and in so doing we will allocate it in such a way that net income will be more evenly affected and thereby make the comparability of the income statement a lot better. So that's the idea now. If we're going to say how are we going to do that the first thing that probably would come up to people's minds is well let's see how long this equipment is going to last and let's allocate the cost over the useful life. In essence that's going to be the straight line method. So the calculation is going to look something like this we're going to say take the cost we do have to then reduce the salvage value. So what is the salvage value? We have to $20,000 salvage value that represents the amount of money that we believe we can sell the equipment for at the end of its useful life. So if we were talking about like a forklift or something then at the end of the useful life maybe the forklift is no longer operational maybe it's completely done for operation or we don't need it but even if it's done for operation then we could still scrap it for metal or something like that that's the salvage value. So that's what we need to depreciate it down to because that is the amount that we believe that we can sell it for at the end of the useful life. So that will give us the amount that we're going to be depreciated. So what's going to happen is we bought it for this going to put it on the books as an asset here then we're going to depreciate it down to $2,375 over the useful life and if we do that then we'll be left with $20,000 which we believe we can sell it for at the end of the time frame. Once we have the amount that we want to depreciate it we're going to divide it by the useful life. In this case they gave us of course the useful life being four years and the question that's going to come to mind is going to be well how did you come up to that four years? So we're going to have to there's various ways we can think about the four years obviously we're going to have to plan out how long we believe the equipment is going to be used for and that's how we would you know come up with the useful life for an accounting purposes. Notice that the tax code will differ the tax code oftentimes will just tell us what the depreciation is in accordance with what type of category the item is in but also notice that the tax code is not necessarily geared towards the best reporting in order to make the best decisions. So the tax code is geared for other types of things such as stimulating the economy and this type of stuff and therefore there could be different types of method accelerated methods so the depreciation calculation for the taxes will be same concepts involved but could differ greatly than the depreciation for the financial statements. The depreciation for the financial statements are what we're talking about here the goal on the financial statements is to have the proper matching in order to have the best reporting in order to make the best decisions therefore the useful life should be the useful life that is most accurate in terms of what we believe the equipment will help us in the future in order to generate revenue. So if we do that division we're going to take the $137.5 divided by four we have $59.375 per year so that's what's going to happen we're just going to depreciate it by the $59.375 each year and at the end of that time period we'll have accumulated depreciation of 237.5 and the cost will remain at 257.5 leaving us with a salvage value of 20 let's see what that will look like then. If we look at a table in terms of the calculations we can think of it in terms of a table then we can think of it in terms of the trial balance and what it will look like in relation to other accounts. So if we think about it in terms of a table we know that depreciation is what we just calculated then we want to think about the book value the book value is going to be the cost less the accumulated depreciation. So we said we just calculated the 59.375 for the depreciation for this period if we calculate the book value then we are going to say that will be the cost 257.5 minus the accumulated depreciation which represents the depreciation over the useful life of the asset up to this point which of course at this point is just equal to year one being the only year that we have done so far and that will give us the book value. Notice what we are not doing is we're not just writing down the equipment itself we are actually making a new account called accumulated depreciation and the reason being is that unlike something like supplies where we actually use the supplies write down the supplies and we can see the physical deterioration in this case we know it's an estimate we know if we bought a forklift that same forklift is there after we wrote it down it's not like we have less of a forklift but we also know that the value theoretically is going to go down over time and therefore we're telling our reader it's an estimate look it's an estimate this is what I paid for it this is what it's gone down by in accordance with the estimate how did we estimate it well we'll tell you we did the straight line over four years with a 20,000 salvage value. So if we look at the journal entry then here's our same calculus here's our number in terms of a table if we think of it in terms of context of the trial balance this is a simple trial balance that we have the assets in green this is before we record the journal entry and we have assets cash counts table and then here's the accounts we're going to work on equipment accumulated depreciation and then we have a liability and the liabilities are represented by credits in this case with brackets and we have the capital we have the revenue at less the expenses and we can see that the debits that are non-bracketed minus the credits that are bracketed here are zero therefore the debits equal the credits we also see that we have a net income of 100,000 that's income not a loss how do we calculate it revenue here less expenses no expenses at this time the only expense that we're going to be looking at is depreciation so that we can see the effect in that case this net income is an is an arbitrary number we're assuming that we we earned 100,000 over this time period so that we can look at the effect on net income for the transaction that will happen also note that the equipment is on the books already at this point at 257.5 which would be a debit to 257.5 when we bought it in a credit to cash or payable when we bought the equipment so now if we look at the journal entry then you would think that if the equipment was on the books here that you would then write it down by the depreciation you would think it would reduce the equipment that's kind of what happens when we think about supplies but remember that that equipment is still on the books and therefore we don't want to write it down because we want to tell our reader hey it's an estimate i want to tell you the reader two things i want to tell you what i bought it for and we also want to tell you what we wrote it down by therefore it's kind of like we're cutting the t account for equipment into two accounts like a seven and an r so we got the seven on this side the debit half of it and then we're kind of putting the credits on another account over here and that we're going to now call a contra asset notice it's still green it's still next to all the other assets but it has a credit bounce represented by the brackets because it's really the reduction half of the equipment here all right so the uh adjusting transaction then it's going to be all adjusting transactions usually have one income statement account one balance sheet account we know the balance sheet account is going to be accumulated depreciation we know the income statement account is going to be depreciation expense in this case we know that expenses only have debit balances for the most part and expenses generally only go up so we're going to make them go up again by doing the same thing to it which is a debit increase in the expense and therefore we're going to credit the other account being accounts payable if we look at what happens when we post this journal entry here then we can see that the accumulated depreciation is going to go from zero up in the credit direction to 59 375 and we can see that the debit of 57 500 minus the accumulated depreciation 59 375 will equal the book value of the 198 125 that we calculated in our table being the book value we can see that the depreciation expense went from zero up to 59 375 what's the effect on net income well it's the 100 000 that we assume we earned before this expense less the 59 375 revenue less expenses means that income went down to 40 625 if we look at equipment purchased in uh the year two so now we're going to say year two this is the table that we already had from the prior year in year one then we're going to say the same calculation we don't need to recalculate it we know that the appreciation is the same for each year each of the four years therefore we're going to say depreciation is once again 59 375 the cost is the same the cost does not change that's what we paid for it the accumulated depreciation on the other hand is the prior year's accumulated depreciation plus the current year's depreciation expense that's one way to think about it or it's the depreciation expense over the life of the asset to this point so the 59 375 plus the 59 375 this way or the 59 375 plus the 59 375 this way in this case will give you the accumulated depreciation of 118 750 how do we calculate the book value we take the cost less the accumulated depreciation giving us the book value of 138 750 so let's look at that in terms of our trial balance so if we look at year two now this is where we started at the beginning of year two meaning that the book value is now the 257 5 less the 59 375 which is the book value here in after year one because that's the beginning we're at the beginning of year two and then we're going to post the transaction so this is the year two before this adjusting entry is recorded then the owner's equity is including all of last year's income and expenses is rolled into the capital account and then we're assuming that we earned another 100 000 in year two so this isn't the same 100 000 earned in year one it's the new 100 000 we're assuming we had the exact same earnings in year two so that we can compare year over year what has happened and what will be the effect of depreciation on it and then of course we have zero at this point in the depreciation expense notice we had to clear out the last depreciation expense to the capital account in order to start the new year so the accumulated depreciation does not go down from year to year it's a permanent account on the balance sheet the depreciation expense is going to be cleared out at the end of each period in this case the end of each year in order to start the counting again in the next year we're assuming that we earned 100 000 once again in year two as we did in year one now we're going to record the transaction and of course the transaction is the same adjusting transaction every adjusting transaction has generally one balanced account one income statement account income statement account is going to be depreciation expense depreciation expenses only go up we're going to make it go up by doing the same thing which is a debit so we're going to debit depreciation expense then we're going to credit a balance sheet account that account being accumulated depreciation and we're going to credit it by the 59 375 and so the if we look at the effect of that transaction the depreciation expense is going to go from zero up to 59 375 in the debit direction to 59 375 what's that due to net income the 100 000 minus the 59 375 is the 40 625 again it's income not a loss the brackets represent revenue credits winning on the balance sheet side the cost remains the same now we got 257 five and the accumulated depreciation went up in the credit direction for a contra asset account being an asset account that has a credit balance rather than the normal debit balance for asset accounts from 59 375 in the credit direction the same thing makes it go up so a credit and a credit made it go up in the credit direction to 118 750 the debit of the equipment the seven side of the t account minus the credit of the accumulated depreciation the other side of the split of the t account that we made will give us the book value of the 138 750 all right so then if we take a look at the next year we're going to now we're at the end of year two we this is where we were at year three we'll look much the same in the straight line method we're going to have more depreciation expense same amount on the depreciation expense the book value calculation cost will be the same cost that we've had of course and the accumulated depreciation is going to be last year's accumulated depreciation plus the current year's depreciation expense or you can think of it as the depreciation expense throughout the life up until this time so the 59 375 plus 59 375 plus 59 375 will give you the 178 125 or prior years accumulated depreciation 118 750 plus the current year's depreciation expense fits now 375 will give you the 178 125 if you subtract these out then you'll get the book value of 79 375 what you want to be careful of when the questions are asked on these types of problems is they can ask you anything they can ask you any of these numbers here they can ask you what is the depreciation expense at a current year what is the cost that's probably they probably want to ask you that as much but they could ask you what the accumulated depreciation is at any given time or what the book value is so it's often students often get good at calculating one or the other getting kind of to a shortcut so that we can calculate one piece well but oftentimes the problem is going to need all the information and therefore it might be good to set up the table in some way that you can just plug in a numbers in accordance to this and if excel of course is great for doing that if you set up an excel worksheet that basically will calculate all the stuff with minimal input for a straight line method problem then that would be very helpful all right so then we're going to say the equipment will look like this here's our table up here if we post the journal entry once again it'll look much the same the journal entry now it looks like this but if we start out year three before we post the journal entry note what it looks like we have the equipment before which is the same value we have the accumulated depreciation which was the cumulative depreciation for year two given us a book value of 138 750 before we record this and we can see that the capital count now includes the net income from the prior year once again we're assuming that we made another 100 000 in year three this is not the same 100 000 that was in year two this is what we have earned in year three assuming our performance was the same and everything other than the expenses which is we're only going to use one right here and then the the accumulated depreciation is now zero why because it got closed out last time in the closing process to the capital account so once again remember that the accumulated depreciation goes up and it never goes away until we sell the item whereas the expenses is a temporary account that gets closed out to the equity section after every period so if we record this it's an adjusting entry we're going to debit an income statement account this account being expense we're going to increase the expense because expenses generally always go up with a debit so we're going to do the same thing to it making the expense go up so we're going to debit depreciation expense and we're going to credit a balance sheet account that balance sheet account being accumulated depreciation and if we post that then we say that accumulated depreciation has a credit balance we're going to credit it making it go up in the credit direction and that is actually a contra asset account because it's an asset in with all the other assets which has a credit balance which is contra to the normal debit balance of assets and then if we calculate the book value 257.5 minus 178.125 would give us the book value 79.375 then if we take a look at the expense the expense goes from zero goes up by the debit here and goes up to 59.375 what's the effect on net income brings it down from 100,000 down to 4006.25 so let's do this one more time we're going to go to year four the final year and then we'll wrap this up so year four looks much the same we've got another expense of 59.375 the cost 257.5 is the same the accumulated depreciation is prior years to accumulated depreciation of 178.125 plus the current year's expense 59.375 given us the 237.5 or you could say it's the all the depreciation expense over the life of the property 59.375 plus 59.375 plus 59.375 plus 59.375 will give you the 237.5 book the book value then cost 257.5 less the 237.5 gives us 20,000 we've seen that somewhere before 20,000 where have we seen that that is the salvage value so remember we we thought that at the end of its useful life being four years we have now ended the useful life in accordance with our estimate then we should be able to scrap it for 20,000 so you might be asking what happens in year five if the thing is still in operation what happens if we're still using this thing next year do we keep on depreciating it because we're still using it and the answer generally is no we don't generally keep on depreciation it and it's easier to see that if we had a case where there was no salvage value so let's say that the salvage value was low or immaterial and we just said we're going to write it down to zero instead of the 20,000 in this case you can see that if we kept on depreciating it even if we're using it in the next year it would make no sense to have a asset like a forklift on the book books that's not only written down to zero but actually has a negative value it's worth negative 20,000 that would make any sense so we can't we cannot take it below the floor the floor obviously if there was no salvage value would be zero if there is salvage value the floor is the salvage value now there is a question as to whether if our estimate is so far off that it's immaterial and we need to fix it then we could have the issue of revaluing the equipment or adjusting the depreciation on it and and extending the useful life at some point but that not being the case what we'll do is we'll say okay we the estimate wasn't perfect but we but we've expensed it and what we cannot do is go past the amount of the value of the cost of the equipment we can't expense more than we paid for the equipment so if we look at this in terms of the trial balance once again we have the same thing we're in year four where we had the book value before at the beginning of the period or before the adjusting entry being the 79 375 which would be the 250 75 minus the 178 125 and note that the accumulated depreciation is accumulating upwards because it's a permanent balance sheet account as opposed to the depreciation expense which is zero before we record the transaction because we haven't because the prior transaction was closed out to the equity section is now part of this for 49 375 and of course we have net income we're assuming it's the same net income same earnings this year that we had last year again it's not the same amount of course we earned 100 000 in year three and now we're assuming we earned another 100 000 in year four just to see some context of the transaction we record the transaction looks much the same it is much the same we debit the 59 375 to depreciation expense making the expense go from zero up in the debit direction to 59 375 what happens in that income 100 000 minus 59 375 brings it down to 40 625 the accumulated depreciation goes from 178 125 up in the credit direction because we're doing the same thing to a credit and the credit makes the credit go up to 237 5 and now if we take the 257 5 less the 237 5 that is 20 000 so we can see on our trial balance that we have a book value remaining now I do want to point out that of course we're talking about one piece of equipment here and a lot of companies of course will have lots of equipment and we will so we will then have to have this number will be grouped these two numbers will group much equipment in it and we'll have to have worksheets that will basically record this depreciation and back up this depreciation schedule so this is a simplified example so that we can see the context here notice that these numbers in reality will often have lots of things involved in it and we'll have very detailed ledgers that will do the calculations of the depreciation so that it will back up these numbers and we'll often have to have of course two of them one for taxes possibly and one for the books of course and maybe even more than that depending on different tax regulations and and our needs in that case so if we look at this in terms of year over year so i'm just going to put the ending trial balance for year one year two year three year four so we can compare this and see what has happened to it we see that the depreciation on the table remains the same each year we can see that on our trial balance it remains the same each year each year we're going to depreciate the same amount we can see that the accumulated depreciation goes up at a fixed rate meaning it goes up at 59 375 each year until the last year year four in which case that's the end of it and it will not go up in year five because we have fully depreciated it down to the salvage value and we can see that of course in the table as well what happens to the book value it goes down at a constant rate so it's going down by the 59 375 in a constant rate leaving us with the salvage value of the 20 000 what happens on net income it's an even effect on net income now remember we're assuming that we assumed we earned 100 000 each year this is not the same 100 000 we're assuming that each year we performed exactly the same on the revenue and the model is showing that we only have one expense so we can see we can isolate that expense and see what would be the effect if that were the case in net income i'm obviously in reality that is in pot heaven would never happen but in the model we're earned the same 100 000 each year and the only expense we have is this depreciation so the effect is the reduction to the net income in the same fashion so we have the same net income all else the same other than depreciation the net income would be the same because we uh evenly allocated it now later that will not be the case so i'm going to show you the later calculations that we'll have this is our allocation here you can see the even allocation and the net income effect next time we're going to go into the double declining method which is the idea that we should be able to depreciate more in the first years than the last years because the equipment will be more efficient in beginning years rather than later years so there is you know some reasoning that's appropriate in this case to do this type of method so we're going to say we should be able to front load the depreciation and thereby what would that do well that would reduce the depreciation and i mean that would increase the depreciation reduce net income in the beginning years and it would increase net income in the later years so that's what we're going to take a look at next time you notice that in year one up here we have an income of 40 000 and if we use this method we got a loss of 28 750 so that's a big difference then in year two we have a gain of 35 under this method 35 625 as opposed to 40 625 then the reverse happens we have 67 8 15 under double declining and the same 40 625 and then income goes up a lot more if you look at the life of these two we end up with the same place meaning we end up with a self book value of 20 000 at the end we end up depreciating over the life of the equipment under any method we use the same 237 5 to leave us with that 20 000 but there's a big difference in when the depreciation happens we call that a timing difference so over the four-year period there's no there's no difference after the four years is over but within that four-year period there's a big difference so the question could be well why do we care why do we care about that if they're basically the same in the end and the answer is that you know there's going to be a lot of effect on our comparison of the financial statements so for the accounting purposes we want the financial statements to be as accurate as possible theoretically that's our goal so the accounting principles would say well which one of these methods are actually the most accurate and there is an argument to say that the double declining or some kind of accelerated method is more accurate because it would give us more depreciation more use in the first years than the later years but there's also some if we're talking about a tax incentive note that if we're jumping to the tax code we have the reverse incentive notice that if we're we're trying to look good which we usually assume that we want to do for financial statement purposes this makes us look bad at the beginning years and better at the ending years which for financial statement purposes is probably not as much what we want for tax purposes that is more kind of what we want because if we're able to take the deduction today we would rather get the tax dollars today and then in the future so for taxes clearly if a business had a choice which they do have less choice because the tax code you basically dictates what our depreciation options will be in a different way than generally accepted accounting principles but if we had the choice we would want to depreciate usually more in the first years than in the last year on taxes when we think about our financial statements then companies often have an incentive to look better in the current years so they might have an incentive to use a straight line method to look better in the current years but the ultimate goal of the of the financial statements is to do what is most accurate in terms of comparing year over year and there is an argument for an accelerated method being better at that now if we wanted to take more time to be more accurate we might try a different type of method than these two we might say hey why don't we use a different type of base rather than just time and it's similar to if we were trying to figure out the value of the car the depreciation of car should we just take the car and divide it by its useful life or should we use something that might be more accurate like taking the mileage of it and using mileage rather than time to depreciate the car a lot of people would say well that would be more accurate neither one of them are perfect of course but that would be the units of production we'll talk about next time in which case we'll talk about that later but in which case now we're going to say well instead of just depreciating over time let's say how much of units that this thing is going to produce so if we're talking about a printer and we know that it's going to print so many pages over its useful life that's what the warranty says then we can divide the cost by the number of pages and then we can see how many pages were printed over the certain time period and depreciate in accordance with that method which would usually be considered to be more accurate what's the problem with that method that means we got to count the pages and then and then depreciate it which is takes more time to do so so those are the pros and cons between these three note that in this example the if we did it with the more accurate method which we would assume that to be more accurate we are showing that the expenses truly are more front loaded meaning that we're getting more use out of it in the beginning years than the later years and that would kind of make sense and that would support an accelerated method so we are now able to calculate depreciation using the straight line method create journal entry related to depreciation explain the effect of recording the journal entry related to depreciation on assets equity and net income