>> Depreciation is the process of allocating the cost of a long term plan asset,
to expense over its useful life.
We begin asset depreciation once that asset is put into service,
meaning when we begin to use it.
In order to calculate depreciation expense,
we need three values.
One is a known amount, the asset cost.
The other two are estimated;
residual value and the useful life.
Sometimes we discover, after some years of depreciation has passed,
that our estimated residual value or our estimated useful life or both are wrong.
When this happens, a company might revise its estimates and
calculate new depreciation expense in the current period and forward.
We never go back and recalculate depreciation expense for past years.
In order to do this,
let's start with our depreciation formula for straight line depreciation method.
Recall that the formula is asset cost minus estimated residual value,
divided by the estimated useful life in years.
We can modify this formula slightly in order to calculate revised depreciation expense.
The formula for depreciation expense with a changed estimate
is asset book value minus estimated residual value,
divided by the estimated remaining useful life.
We would use revised residual value and or revised remaining useful life,
depending on any changes to those amounts.
So let's look at an example.
On January 1, the Pixies purchased a touring bus for an upcoming concert tour.
The bus cost $250,000 and has an estimated useful life of five years.
At the end of five years,
it's estimated that the bus will have a value of $50,000.
Using the straight line method,
let's calculate the amount of depreciation expense
and the asset's book value at year end.
The formula is cost minus residual value divided by useful life in terms of years.
So $250,000 minus $50,000,
that's 200,000, then divide that by five years and we
get annual depreciation expense of $40,000 per year.
We can record the adjusting journal entry by debiting
depreciation expense and crediting accumulated depreciation for $40,000.
The book value is the cost of the asset minus its accumulated depreciation.
So the cost of $250,000 minus accumulated depreciation of $40,000,
gives us a net book value of $210,000.
Now let's assume in year two,
it was decided that the tour bus wasn't going to last
five years nor be worth $50,000 at the end of its useful life.
Assuming that the bus would last three more years and be worth $30,000 at that time,
lets revise depreciation expense for year two and forward.
The book value is $210,000 minus the revised residual value of $30,000,
divided by the revised remaining useful life of three years.
Means that in years two, three and four,
we would record $60,000 of depreciation expense.
After four years, the book value is the cost of
$250,000 minus the accumulated depreciation of $220,000.
This gives us a net book value of $30,000,
which is the residual value.
So the tour bus can't be depreciated below its residual value.