 Hello and welcome to the session in which we would look at various depreciation methods. So what's the big idea of depreciation? Well, the big idea of depreciation is expensing the cost of property, plant, and equipment, expensing the cost of those long-term asset, of those fixed asset under the principle of matching. What does that mean? Well, simply put, when we buy an asset, let's assume we bought a machinery or a vehicle, the vehicle is an asset. So we're going to park this asset, let's assume we purchase a vehicle for $10,000. So we're going to have $10,000 of assets, the vehicle on the balance sheet. This is the balance sheet. Then what's going to happen is eventually we are going to be using this asset to produce revenue. So we're going to be producing revenue on the income statement. This asset, it's going to help produce revenue. Well, when it's going to help produce revenue, we need to expense it. We need to expense it. So we need to allocate some of that expense, some of that cost. This is the cost, some of that cost to the income statement. This allocation process is called depreciation expense. So simply put, we're going to say, for the sake of illustration, this asset, this $10,000 asset will serve us for five years. As a result, we will assume that each year it's producing, it's serving the company and at a rate of $2,000 per year. I just assume it's going to serve the company equally. So every year we are going to expense through an account called depreciation expense. We're going to expense $2,000. So over a five-year period, we'll expense the whole thing. Here we are assuming there's no salvage value. The reason I'm doing this example, for the sake of illustrating the big picture. So that's the idea of depreciation. Simply put, gaps as allocate the asset cost as equitable as possible to the period which the service are obtained from its use. So here we're assuming this machinery, this vehicle, whatever we purchase, it's going to serve us for five years and there is zero salvage value. What is salvage value? We'll talk about salvage value right now. So how do we compute depreciation? First, we have to find our depreciable base. So there's few terms we need to be familiar with. What's the depreciable base? The depreciable base is the cost of the asset, which as we said for the sake of our example, $10,000 minus something called salvage or residual value. I'm going to assume or I assumed already that my salvage value for my example is zero. Now, what is the salvage value or residual value? The salvage value or residual value is how much can you get for this asset after its useful life? I'm going to assume zero for the sake of this example. It could be $200. It could be $1,000. It could be any number, but I'm going to assume for the sake of simplicity is zero. So depreciation would require that the cost of the asset, which we learned in the prior recording, estimate the salvage or residual value. And remember, I mentioned the word estimate because this is simply an estimate. Also, we have to estimate the useful life of the asset, need the asset useful life. This is also an estimate or the activity level. And we're going to see why we need the activity level for some depreciation method. So we need three things. We need cost, salvage value, and we need the life or the activity. And we're going to see what activity is when we work an example. So those are the three things. One, two, three. Okay. Now, there are several methods that we can utilize to compute depreciation. There's more than one method because GAB doesn't specify what method. As long as it's equitable. Well, straight line is one of them. This is the easy method to use and mostly used for financial accounting and reporting. Units of production or activity method. And this is where we will need the activity level. We can use something called accelerated method. And under the accelerated method, we have two specific methods, the sum of year's digit and the declining balance method. Under the declining balance method, we could have 200% declining balance, 150, 175 would look at an example. So we could have many types of declining balance method. Then we have special depreciation method, which we'll cover briefly in a separate recording, group and composite method, hybrid or combination method. So in this session, we're going to be looking at the straight line units of production and accelerated method. This topic is covered in intermediate accounting as well as the CPA exam. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. If you're studying for the CPA exam, I don't replace your CPA review course. You keep it. I'm a useful addition to your CPA review course. 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Take a look at my LinkedIn recommendation. Like this recording. Share it with other connect with me on Instagram, Facebook, Twitter, and Reddit. The best way to illustrate these depreciation methods is to actually work an example. So we're going to assume we purchase on January 1st a machine with a cost of 500,000. It has an estimated useful life of five years. Estimated salvage value is 50,000, and it can produce 40,000 unit. Now I'm going to show you a few things. I just want to make sure you're aware of them up front. The first thing I'm going to remind you that what we did on the prior slide is how to compute the depreciable base. If we take the cost of the asset, which is half a million, minus the salvage value, 50,000, that's going to give us 450,000. This is called the depreciable base. Now what does that mean? What does the depreciable base mean? It means this is how much you are going to depreciate. Simply put, do not depreciate the salvage value. That's just the point I'm trying to make. And do not depreciate the salvage value. The reason I'm saying this, because we're going to have many methods and none of them will depreciate the salvage value. So that's why I'm making this point up front. So you will see why every time when we book depreciation we have $50,000 left, because you don't depreciate the salvage value. The second thing I want to show you is the journal entry to book depreciation. We're going to increase depreciation expense and we're going to increase accumulated depreciation. Accumulated depreciation is a contra asset account. Specifically, contra asset to the asset that's depreciating. So if we're depreciating the machinery, it's going to reduce the machinery. Simply put, on the balance sheet, we're going to have the cost of the asset and right underneath it, we're going to have accumulated depreciation and those two together, cost minus accumulated depreciation will give us the book value. You also need to understand that year after year, accumulated depreciation, it accumulates, it increases. As accumulated depreciation goes up, obviously the book value goes down. So as your cost is fixed, so this number is fixed. So if this number is fixed and you constantly increase accumulated depreciation, your book value constantly goes down. So this concept applies to all depreciation methods and that's why I'm putting them up front. The first method we're going to be using is called the straight line formula, which is the straight line and the formula for it is cost minus salvage value divided by the life of the asset. So let's start to go ahead and look at some numbers. But again, the journal entry is debit depreciation expense, credit accumulated depreciation. Either method you are working, it doesn't matter. So for the straight line method, let's take a look at the numbers. The straight line method is cost minus salvage value divided by five years life, which is going to give us 90,000 per year. Now let's take a look at how we complete what's called a depreciation schedule. So the companies, what they do, they prepare a depreciation schedule and most software, they do this. So if you have a fixed asset software or a property, plant and equipment software, one divide the asset, the input, all the figures, and basically you're going to take the depreciable base multiplied by the depreciation rate per year. Now where did this coming from? One fifth. Remember, if we are depreciating the asset equally, and this is what the straight line method implies. The reason it's called the straight line method is because for year one, year two, year three, year four, and year five, the depreciation, it's going to be the same, 90,000. Okay, that's why it's called the straight line. Therefore, when you graph it, the depreciation is the same. Now this one divided by five equal to 20%. So this is the straight line rate. How do you get the straight line rate? You will take one divided by life. This happens to be five years. Now if it's a 10 year, it's one divided by 10, the rate will be 10%. Then you take the depreciable base, the depreciable base times one fifth equal to the depreciation expense of 90,000, which is the same that I did here. So you can take the depreciable base times the rate or you can use the formula up here. Either way, it's going to give you 90,000. Now your accumulated depreciation is 90,000. Your book value is 410,000. The book value, again, it's the cost of the asset, which is 500,000 minus so far the depreciation of 90,000. If we look at year two, let's take a look at year two, give me one second here, it's going to roll. Year two, same thing, 450,000 times one fifth equal to 90,000. Now your accumulated depreciation is 180 and obviously your book value goes down to 320. Year three, 450 times one fifth. So notice the amount of depreciation expense is always the same, but accumulated depreciation is going up. Therefore, your book value going down. Remember, accumulated depreciation, let me just draw the t-account here, it's a counter asset. So it stays with you from year to year. So year one, year two, year three, and this is how we're coming up to 270,000 by year three because it's accumulating. It's a balance sheet account. It's a permanent account. It doesn't go away. When do we reduce accumulated depreciation? It's when we sell the asset. Then year four, 450 times one fifth, 90,000, and year fifth. And basically at the end, we're going to have 50,000 remaining. We don't depreciate this remaining 50,000. Notice this was the depreciable base of 450, and this is the amount that we depreciate over a five-year period. And how did we do it? We did it equally under the straight line method. So this is important to understand the depreciation schedule. The second method we're going to look at is unit method or activity method. Now again, we purchased this asset and we said that this asset will produce 40,000 unit. Now assume the company produces 3,500 unit in year one. How much depreciation do we take? Well, the first thing we have to do under the units method or the activity method is to find our depreciation per one unit. How do we compute that? We'll take the cost of the asset minus the salvage value divided by the total units that this asset can produce. And if we perform this computation, we find out that this asset is depreciated at $12, $11.25 per unit. Well, that's easy, 3,500 unit times 1125. Our year one depreciation is 39,375. Debit depreciation expense for that amount, credit accumulated depreciation. In year two, the company produced 4,200 unit. Again, what we do is we'll take 4,200 times 1125 and we're going to come up with depreciation expense of 40,250 and 47,250 for accumulated depreciation. So notice year two because we use the asset more, it's going to be depreciated more. Let's assume in year three we did not use this asset. It means we produce zero unit. It means we have no depreciation expense for this asset. It's based on the activity. And let's assume in year three, we produced, I don't know, so far we produced, let me see, 3,500. Let me see, 3,500 plus 4,200. So far we have produced 7,700 units. So we have 40,000 in total minus 7,700. We still have 32,300 of potential depreciation. Let's assume in year three for the sake of illustration, we produced 50,000 unit. Well, guess what? We only can depreciate 32,300 times 1125 unless we make a depreciation revision of the estimate of the unit produced. Simply put, you can only depreciate up to 40,000 unit. That's the point I am trying to make here. So this is the activity level of units of production. It's not based on the time. It's based on the activity. Another method that's called, this is one of the accelerated method. Accelerated means more depreciation is taken up front. It's called the sum of year's digit. And as the name of it suggests, the sum of year's digit. So you're going to take the sum of the year's digits. For example, you're going to have a ratio, a numerator and a denominator. And the denominator, you're going to have the sum of the year digit. For example, we have an asset that's going to last us five years. So we're going to take the sum of year's digit, five, four, three, two, and one. And we're going to add them all together and they're going to add up to 15. Now this is your denominator. What do we put in the numerator? In the numerator, we're going to have, and you have to be very careful, the number of years estimated, the number of years estimated life remaining as of the beginning of the year. For example, for this asset, for year one, we're going to have five and then, five in the numerator. So for year one, it's going to be five divided by 15 because we still have five years to go as of the beginning of the year and the denominator is 15. For year two, we're going to have four years remaining, four divided by 15. So the denominator will always be the same. The numerator will be how much time left here in terms of year, but how much time left as of the beginning of the year. Now the best way to illustrate this is to actually look at an example. So the depreciation expenses will take the depreciation base, which is we know the depreciation base times the ratio, the numerator and the denominator. So simply put, for year one, we're going to take 450,000, which is the depreciation base. We have five years remaining and we're going to multiply it by five remaining divided by 15. Our year one depreciation expense is 150. The book value becomes 350, which is 500,000 minus 150. Year two, we have four years remaining, multiply by 415 equal to 120. Now our year and book value is 230 because now what we're doing, accumulated depreciation becomes 270 and 500,000 cost minus accumulated depreciation equal to 230. So notice we depreciated most of the asset in the first two years and that's why it's called the accelerated method. Year three, 450 times 315, remaining three divided by 15,000, and the book value again will go down. Why? Because now we have three years of depreciation. We add all this up in 500,000 minus those three figures that's going to give us 140,000. Then we'll go through year four and year five. Notice in total we depreciated 450,000 and we don't depreciate the remaining 50,000. The remaining 50,000 is the salvage value and I said this at the beginning and I'm going to remind you here that the salvage value is not depreciable. Let's take a look at another accelerated method called declining balance and specifically we're going to look at the double declining balance. We have money declining balance. We could have a double declining balance, 175 declining balance, 150 declining balance. So how do we compute the declining balance? We're going to take one divided by the life of the asset, multiply that number since we're using double, we're using the double declining balance multiplying by two. For example, if we're doing 150, we multiply it by 1.5, but that's the rate that we are using. To come up to something called the double declining rate, I call the DDR. Now we're going to take the DDR times you have to be careful, not times the depreciable base, be careful, times the beginning of the period book value. What is the beginning of the period book value? What's the book value? I kept showing you what's the book value throughout this session. The book value is the cost minus accumulated depreciation. This is the book value. Now for year one, the cost minus zero is the book value because at the beginning of the year, there was no accumulated depreciation. So for the sake of this illustration, we have one divided by five times two, which is 20% times two. 20% remember is the straight line. So the double declining is straight line times two. So our double declining rate is 40%. Now what we do, we're ready to compute our depreciation. We're going to take the book value as of the beginning of the year. Remember, the book value, not the depreciable base. For the double declining balance, you would use the book value multiplied by 40%. That's going to give us depreciation expense of 200,000. We have 200,000 of accumulated. The book value is 300,000. Year two, your book value is 300,000. Your book value at the end of year one is your beginning of the period book value at year two times 40% equal to 120. Notice, between year one and year two, you depreciated 320,000. You depreciated most of the asset. That's why it's called accelerated method. It's going to give you more depreciation early on in the life of the asset. Year three, 180 becomes the new book value times 40%. Year four, 108 times 40%. And year five, if you take 64,800, that's the book value times 40%. If you take 64,800 times 0.4, that's going to give us 25,920. The only depreciation we can take for year five is 14,800. Why? Because remember, I cannot depreciate below 50,000. As of year four, what's left in the book value is 64,800. Now, the maximum I can take of depreciation is some number that's going to give me remaining 50,000. That number is only 14,800. So this number here is a plug because the actual number, if I take the book value times the double declining rate, will give me 25,920. So you have to be careful. You have to be careful. In all methods, you can, all the methods cannot depreciate below the book value. You cannot depreciate below the book value. But sometime, the salvage, sorry, you cannot depreciate below the salvage value. But be careful. Sometime, the salvage value is taken into the, into the computation. Sometimes it's not. For example, here, we ignore, for example, we ignore salvage value for the computation versus in the previous method, notice here the depreciation base already deducted the salvage value. So you have to, you have to remember this, just something that you have to memorize, something you have to memorize. Well, the best way you told to, to kind of learn this, you have to work additional multiple choice, additional exercises. And the best way to do this is to go to my website, farhatlectures.com and do so. In the next session, I would look at a partial year depreciation because in this example, I kept it simple. I told you, I purchased the asset January 1st. Well, that's not really true. That's not what happened in the real world. You need to know what happened when you buy the asset other than January 1st. What does that mean? It means in year one, we're going to have a partial year depreciation. We would look at this in the next session. 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