Mark Farber: Hi, I'm Mark Farber, and this is Accounting Fundamentals.
Today, we're going to talk about what I think is one of the coolest things, and I know,
the word 'cool' doesn't normally come to mind when you think about accounting.
This is one of the coolest things in accounting.
We're still dealing with adjusting entries, so entries that are made at the end of an
accounting period in order to get the accounts ready to prepare for natural statements.
And we're going to talk about depreciation, sometimes referred to amortization or depreciation.
I'm going to call it depreciation for today.
Now, again, we're going to jump right into an example to take a look at what this means.
So imagine that on January 1st, and let's put in a year here.
2005.
January 1st, 2005 a company goes and buys a piece of equipment for $55,000.
This equipment has a useful life of 5 years, so they anticipate that they're going to make
use of this piece of equipment for the next five years.
And it has what we call a salvage value or a residual value, you'll see both terms, residual
value, of $5,000.
Which means that at the end of the five years, the company expects to be able to either sell
this piece of equipment or at least make use of scrap metal or something and get $5,000
back from the original $55,000 that they paid for it.
Kind of like if you buy a car and you plan to keep the car for a certain number of years
and then sell it for something in the future, that would be the residual value, what you
think you're going to sell it for in the future.
Again, if we think about cash accounting, under cash accounting, we would record an
expense on January 1st of $55,000 because the company has purchased this for $55,000
cash on January 1st.
In the very first month, there'd be this huge expense of $55,000, and then there'd be no
expense for the remaining five years.
We're just going to look at this annually, so the next four years wouldn't have any expense,
despite the fact that the company gets benefit from this machine.
Instead, what we do is we do something called ... we use something called depreciation.
And we'll go through the steps of this very slowly.
On January 1st, 2005, they purchase the equipment, so we're going to debit equipment because
our asset has increased, $55,000, and we're going to credit cash.
I'm assuming they paid cash in this case.
Okay?
Now, let's just set up some T accounts here, for the ones that we want, anyhow, I don't
care about the cash so much, but I'm going to set up an equipment account.
And I debited equipment $55,000, so I'm going to put that in here, because that's going
to go onto my balance sheet, ultimately, that $55,000.
Now, we've gone through the first year, it's now December 31st, 2005 and the company has
used up some of this machinery, okay?
A couple of ways to think about it: number one, the equipment is no longer worth $55,000.
It was worth $55,000 when it was brand new, but we all know that a piece of a equipment
that's a year old isn't worth what it was worth when it was brand new.
We have to reflect that somehow.
We have to show that its value has declined over time.
More importantly, this ... there's no expense in there, so we haven't put any expense onto
the income statement yet to show that we've used this equipment in order to generate revenue.
Regardless of what the equipment does, it was used for the purpose of creating revenue
in the company.
December 31st, we now have to account for that.
So first, we've got to do a couple of quick, well one quick calculation.
We have to calculate the annual depreciation expense.
How much do we depreciate this?
My depreciation expense, I'm just going to slip it in over here, actually ... depreciation
expense, is going to be equal to the cost minus the residual value over the useful life.
Once again, I've not given myself room to maneuver, so I'll move over here.
The cost in this case was $55,000.
That's what we paid for the machine, but because they expect to get $5,000, they're not going
to depreciate the $5,000.
There's no expense incurred in that, so we're going to reduce this numerator by that amount.
$5,000 over the useful life, and the useful life, we were told, was five years.
That's $50,000 over five years.
That's going to be $10,000 per year.
Every year this company is going to use up $10,000 worth of that machine.
That means on January ... sorry, on December ... doing this annually, 31st, 2005, the company
is going to debit the expense and we call the expense depreciation expense, for $10,000,
the annual amount.
Here's where it gets a little interesting.
When we looked at supplies, this is very similar to what we do with supplies, if you recall.
We purchase supplies throughout the year and we kept saying we would debit the supplies
account every time we bought more supplies and then at the end of the year, we figured
out how much supplies did we use and we credited the supplies account for that amount, so that
at the end of the year, our supplies account would have the exact amount in it that we
used up or that was available for the next year.
Over here, it's a little bit different.
We could credit equipment, because that's what we're trying to do.
We're trying to decrease the value of our equipment over time.
But we don't: we always want to keep that $55,000 available on our balance sheet, so
we can always see what we paid for the equipment.
We need to create a new account and the new account that we create is called accumulated
depreciation.
We're going to credit it $10,000.
Now accumulated depreciation is called a contra-account, and I'm going to put it over here and you'll
see why in a second.
Here's my accumulated depreciation and I'll just put in my depreciation account.
Remember, we put $55,000 into our equipment account.
Now at the end of the first year, we've depreciated it by $10,000, so we have $10,000 depreciation
expense, debit $10,000 depreciation expense, we credited accumulated depreciation.
The reason this is called a contra-account, relates to how it's going to be recognized
on the balance sheet.
On this company's balance sheet, what you will see is the following: you'll see equipment,
$55,000.
And then you will see less accumulated depreciation.
Which in this case is $10,000.
So that the net value of that equipment on the company's balance sheet is going to be
the difference: $45,000.
Just like with other things, whether it was pre-pays or unearned revenue, this just continues
every year, so on December 31st 2006, the company's going to record another year of
depreciation expense.
The depreciation expense will be $10,000 for the year, they'll put another $10,000 in accumulated
depreciation so that it will now be $20,000 and if I can do this somewhat neatly, that
becomes a 2.
That becomes a 3.
At the end of the second year, we equipment of $55,000, minus $20,000 of accumulated depreciation
or two years' worth, leaves us $35,000 for the net asset value.
That's how depreciation works.
And every single one of the assets within a company needs to be depreciated, sometimes
individually, sometimes as groups, depending on how they were purchased and how long the
useful life is and all sorts of other things.
This is one way in which companies can go about depreciating things.
In future courses, you'll learn other ways that are a little bit more complex than this.
This very simple way is referred to as straight-line depreciation.
The reason we call it straight line is because we're depreciating by the exact same amount,
in this case, $10,000, every period.
The value of this equipment is going to drop on a straight from $55,000 to 45, 35, 25.
Down.
Eventually, the equipment will be worth $5,000 after five years, which is what the company
thinks it's going to be worth, because that's what they plan to sell it for it.
That's in a nutshell how depreciation works.
We'll continue on with a few more of our adjusting entries and then get into closing out our
books and preparing our financial statements.