Depreciation is the process of allocating the cost of a long-term plant asset to expense over its useful life.
If a plant asset is going to generate revenue for five years,
then the cost of the plant asset needs to be spread to expense over five years.
This keeps us in alignment with the matching principle.
By the way, depreciation is not a valuation process.
So many of you are familiar with the concept that you buy a new car and drive it home and immediately it depreciated in value.
That's fine. That’s not the same thing as accounting depreciation.
Accounting depreciation is spreading the cost over many years.
In order to calculate depreciation expense, we need three data points: the asset cost, which is a known amount.
We’ve already learned how to calculate the cost of an asset, but if you missed it, please go back and re-watch the video with that name.
We also need the residual value of an asset. This is how much we think the asset will be worth at the end of its useful life.
This is commonly referred to as the salvage value.
In fact, residual value and salvage value are interchangeable terms so please be familiar with that.
Finally, this amount is estimated.
We don’t know for certain what an asset’s value will be in 5 or 10 or more years from now.
The final piece of data is the useful life of the plant asset. Will it last 5 or 10 years or more?
This needs to be determined. It is also an estimate.
There are three primary methods of calculating depreciation expense.
Although not inclusive, these methods are used by more than 92% of the major US companies.
They are the straight-line method, the units-of-production method, and the double-declining balance method.
The straight-line method is the most common method.
It takes the cost of a plant asset and spreads it evenly to expense over the asset’s useful life.
The units-of-production method is an activity-based method. The more activity, meaning miles driven or units produced,
the more depreciation expense recorded.
The double-declining method accelerates depreciation expense in the early years of a plant asset.
So as an asset is more profitable and efficient, more depreciation expense is matched against that.
As the assets needs more repairs and is less profitable and less efficient,
less depreciation expense is recorded.
I would encourage you to watch the videos on the specific depreciation method examples.
Once we calculate depreciation expense,
we make the following adjusting entry to record the amount.
We debit Depreciation Expense and we credit Accumulated Depreciation.
Recall that Accumulated Depreciation is a Contra-Asset account.
This means that it is an asset, but it has a normal credit balance rather than debit balance like all other asset accounts.
The way that plant assets are presented on the balance sheet is similar to this example.
The cost of the plant asset is listed.
We report and subtract the amount of accumulated depreciation.
This gives us a plant asset net amount or what is commonly called net book value.
Net book value is an important concept as it relates to depreciation.
First, we cannot depreciate any plant asset so that its net book value is less than residual value.
When we learn about specific depreciation methods, it’s important to remember that we might record
less depreciation expense than we calculate if doing so would drop our book value below the residual value.
Additionally, book value is part of the depreciation formula for the double-declining balance method.