 Hello, and welcome to this session. This is Professor Farhad, and this session we would look at depreciation, which is a form of deferral or prepaid adjustments. Now, I like to cover depreciation separately, because it's a little bit different than prepaid expenses and a little bit different than supplies. This topic of depreciation is typically covered in the financial accounting course and introductory course. Obviously, you need to understand this on the CPA exam. As always, I would like to remind you to connect with me on LinkedIn if you have not done so. YouTube is what you would need to subscribe. I have 1,600 plus accounting, auditing, finance, and tax lectures. This is a list of all the courses that I covered. If you like my lectures, please like them. Click on the Like button. It doesn't cost you anything. Share them. Put them in Playlist. If they benefit you, it means they might benefit other people as well and connect with me on Instagram. On my website, you'll have resources such as additional questions for the CPA, True, False, Multiple Choice. If you're looking for something to supplement your courses, check out my website. So what is depreciation? What's the idea of depreciation? Well, we have to understand that we have assets. And hopefully, we know the definition of an asset. Asset is a resource that provide benefit to the business, provide benefit. Now, we have certain assets that provide benefit for one year or one period, inserting assets that provide benefit for many periods. For example, if we bought a vehicle or a truck, well, a vehicle or a truck will be with us several periods. What do we call those assets that service the company many years? Plant assets. Those plant assets like a truck, like a building, like a warehouse, like equipment, those assets, they service the company for many years, for many years. We call them plant asset. Now, what do we have to do with plant asset? Well, eventually, eventually, eventually, all assets, no exception, all assets, all assets eventually get expensed. So when you buy a truck, when you buy a truck, let's assume you bought a truck for $10,000. That's the truck. Now, this truck, let me just go through the whole process. So let's assume I bought a truck for $10,000. When you buy the truck, you debit a truck, $10,000, and we're going to assume you paid cash, $10,000. Now, here's what's going to happen. The truck is an asset, and on the balance sheet, you're going to have a truck that's worth $10,000. That's on the balance sheet. Now, this truck, it's going to be used. It's going to be used, and I'm going to tell you, it's going to be used for five years. We plan to use this truck for five years. One, two, three, four, five. Now, what's going to happen if this truck is going to be used up for five years? Therefore, we have to expense it. It has to be expensed, because remember, we have to comply with the matching principle. We have to match it with the period in which it's benefiting. So what's going to happen every year, we're going to expense. I'm going to make it easy for you because it's at $10,000 over five years, so every year we are going to expense $2,000. So every year of this $10,000, $2,000 goes to the income statement as an expense. Now, did we use this truck exactly for $2,000? No, we might have used it for more or for less. But to make our life easy, we're going to give every year you got it $2,000 of expense. And by doing so, we would expense the truck over a period of five years. This process is called depreciation expense, and this is what depreciation expense. Expense in this truck over the cost of this truck, the $10,000 over five years. So let's look at the official definition. Instead of expensing the cost of a plant asset in the year it's purchased, we would allocate. We will expense it or spread out the cost, which is $10,000 over the useful life of five years. This is what depreciation is. So the proper formula is this. We'll take the asset cost for our example was $10,000 minus something we call the salvage value. Now the salvage value we're going to assume it's zero. I'm going to explain the salvage value in a moment divided by the estimated useful life I said five years. And now we have what's called the straight line depreciation expense. Why is it called the straight line? We'll talk about this when we get to the depreciation chapter, okay? Now, so useful life. You remember we divided by the useful life for our purposes was five years. This is an estimate. Useful life is a period of time that an asset expected to help produce revenue. We just estimate it. We might sell it after two years or we may keep it for 10 years, okay? But we have to estimate a useful life. And we'll talk about those scenarios if we sell it early or we got into an accident or we throw it away or we exchange it later on. The useful life expires as a result of wear and tear or because it's no longer satisfied the needs for the business. If we don't want that truck again, we don't have to wait five years. We can cut it out at three. It doesn't matter. That's the useful life and we'll deal with that later on. The salvage value, again, it's an estimate. I told you it's zero. Basically the salvage value is the expected market or selling price of an asset at the end of its useful life. So simply put after five years how much can you sell this asset for? People don't know how much you're gonna sell something five years later. You don't know how much you can sell something five months later and sometimes five days later. Therefore you estimate. In the real world we always estimate zero because it's easier. This term is also called scrap value or residual value. Same thing. If you say the word scrap value or residual value it's the same thing. It's the best way to look at depreciation is to work an example using the formula. So let's take a look at this. We bought equipment on December 31st for 26,000. We estimate this equipment to have a useful life of five years. And we expect that the equipment to have a salvage value of $8,000. This is how much we expect to sell it after five years. And we purchased this equipment December 1st. Now it's December 31st. What happened is we have to depreciate, we have to record an expense, a depreciation expense of one month. Because one month went by and this asset kind of was used up. It's provided services. It provided services for one month. Therefore fast forward expect the equipment to be worth 8,000. Okay, that's fine. If it's gonna be worth 8,000 that means we are only going to expense. Because remember, we bought it for 26. We expect to have 8,000 left. So what are we going to expense? We are going to expense only 18,000. Not the full amount because we cannot, we don't expense. So this salvage value we don't expense. Why? Because we expect to sell it. We expect to get our money back. That's why we don't expense, okay? So 18 month. So the amount that we're gonna be expensing over five years is 18 month. And we're gonna spread it over 60 month. Why 60 month? Because it's five years and we're computing the depreciation per one month. So let's take a look at the formula here. So we're gonna take the original cost of the asset which is 26,000 minus the salvage value of the asset which has happened to the 8,000. And that's gonna give us something we call net cost. Sometime we call this D and other textbook. They call it the depreciable base. It's how much we are going to depreciate. We are only going to depreciate 8,000 over five years. Not 26,000. Why not 26,000? Because this amount of 8,000 is not depreciable. We cannot depreciate the 8,000. So let's compute the depreciation per one month. So let's go through the formula. So if we take cost, 26,000, 8,000, 26,000. Minus 8,000 divided by 60 month. The depreciation per month, it's going to be 300 dollars. So let's take a look at the adjusting entries. The first thing we're gonna do is we're gonna debit depreciation expense because we have to record depreciation expense. Then for every debit, we need a credit. What are we going to credit? We are going to credit a new account called accumulated depreciation. Now this is a new account, okay? Now, generally speaking, when I ask the questions in class, what should we credit? Usually students says we need to credit the equipment. We don't credit the equipment. We keep the equipment at its value cost, historical cost of 26,000. So this account here, this accumulated depreciation serve the purpose of reducing the equipment without touching the equipment account. So accumulated depreciation is what type of an account? It's a new account. The type is contra asset. And specifically the contra asset here is for the equipment. So we created this account to service the equipment. How does it service in the equipment? It's reducing equipment. It's reducing the equipment account. So we don't credit the equipment account. We credit accumulated depreciation, okay? So now we record the depreciation for one month. Now, from a journal entry, we debit depreciation expense goes up, accumulated depreciation equipment goes up. Again, this is a contra asset account. Now, how do we show the contra asset on the financial statement? Contra asset goes on the balance sheet. This is a partial balance sheet. And every month contra the accumulated depreciation it accumulates after three months. So December 300, January 300, February 300, so far this is the third month. That's why we have 900. First of all, contra accounts are kind of a reduction in the asset. So notice, we'll take the cost of the asset. We list the cost of the equipment at 26,000. Less 900 will give us 25,100. Now, this account here, we call it the book value. We call this the book value of the asset, the book value of the asset, okay? So this is the book value after three months. And every month that goes by, every month that goes by, this account goes up by 300 and this amount goes down by 300, okay? So this is what happened every month. This is what happened every month. Now, in the next session, now we looked at depreciation, in the next session we're gonna look at a new type of deferral, which is the deferral of revenues or unearned revenues. Again, it's part of the adjustments. As always, I would like to remind you if you like this recording, please click on the like button, share it, put it in playlist. If you're looking for additional resources, please visit my website. You'll have access to additional material and you will benefit yourself, especially if you're studying for your CPA exam. Accounting is a tough major. It's a rewarding major. 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