I'm Larry Walther and this is principlesofaccounting.com, Chapter 10.
I'm Larry Walther and this is principlesofaccounting.com, Chapter 10.

In this module, we will look at service life and depreciation and
In this module, we will look at service life and depreciation and

then begin to consider concepts and terminology related to depreciation.
then begin to consider concepts and terminology related to depreciation.

First of all recognize that depreciation is not a process of valuation,
First of all recognize that depreciation is not a process of valuation,

it is a process of cost allocation, we want to spread the cost of an asset over
it is a process of cost allocation, we want to spread the cost of an asset over

its service life, the period of expected benefit in other words.
its service life, the period of expected benefit in other words.

And many factors drive or effect service life, physical deterioration
And many factors drive or effect service life, physical deterioration

such as wear and tear, or the effects of wear and tear, obsolescence.
such as wear and tear, or the effects of wear and tear, obsolescence.

New technology may render something out of date.
New technology may render something out of date.

Or indeed, we can have inadequacy that arises.
Or indeed, we can have inadequacy that arises.

The machine is no longer large enough or big enough or
The machine is no longer large enough or big enough or

fast enough to meet our particular needs.
fast enough to meet our particular needs.

So we will take all of those factors into account in determining what we expect
So we will take all of those factors into account in determining what we expect

the estimated service life of an asset to be.
the estimated service life of an asset to be.

I recognize that some assets have an indefinite life such as land, so
I recognize that some assets have an indefinite life such as land, so

we will not be depreciating those particular type of assets.
we will not be depreciating those particular type of assets.

Now, this gives rise to spreading the cost of the asset
Now, this gives rise to spreading the cost of the asset

over the service life through a process known as depreciation.
over the service life through a process known as depreciation.

And the pattern by which the cost is allocated in each of the periods involved
And the pattern by which the cost is allocated in each of the periods involved

is dependent upon the depreciation methods selected.
is dependent upon the depreciation methods selected.

There are a number of methods such as the straight line that you've already been
There are a number of methods such as the straight line that you've already been

exposed to but
exposed to but

we'll also look at units of output and double-declining balance methods.
we'll also look at units of output and double-declining balance methods.

But before we look at specific methods in subsequent modules, let's consider issues,
But before we look at specific methods in subsequent modules, let's consider issues,

let's assume, very simply, we have a $100 asset with a four year service life.
let's assume, very simply, we have a $100 asset with a four year service life.

And we're going to assume under straight-line depreciation
And we're going to assume under straight-line depreciation

that we'll allocate $25 to each accounting period.
that we'll allocate $25 to each accounting period.

And so graphically we see that our depreciation's uniform over each time
And so graphically we see that our depreciation's uniform over each time

period, and that may seem very logical.
period, and that may seem very logical.

However, if we also consider maintenance costs,
However, if we also consider maintenance costs,

if you think about an automobile, as it gets older,
if you think about an automobile, as it gets older,

you expect maintenance costs to rise, things start to break and wear out.
you expect maintenance costs to rise, things start to break and wear out.

And so over time, you might not have any maintenance costs in the first year and
And so over time, you might not have any maintenance costs in the first year and

then it may go up in subsequent years.
then it may go up in subsequent years.

And when you put depreciation and maintenance costs together, what you see
And when you put depreciation and maintenance costs together, what you see

is, we actually might be showing even though the usage of an asset is uniform
is, we actually might be showing even though the usage of an asset is uniform

over its service life, we might actually see that our total reported costs,
over its service life, we might actually see that our total reported costs,

the depreciation plus the maintenance cost, is going up.
the depreciation plus the maintenance cost, is going up.

Well was that logical?
Well was that logical?

Well it may be but it may not be.
Well it may be but it may not be.

If we instead use an accelerated depreciation method where we take
If we instead use an accelerated depreciation method where we take

more depreciation in earlier years and less in later years.
more depreciation in earlier years and less in later years.

When we couple that with maintenance costs and
When we couple that with maintenance costs and

look at a combined picture you can see we might actually have a more uniform
look at a combined picture you can see we might actually have a more uniform

recognition of costs through an accelerated depreciation.
recognition of costs through an accelerated depreciation.

Initially, straight line may seem logical, and it is indeed a popular method.
Initially, straight line may seem logical, and it is indeed a popular method.

But when you consider the total cost of utilizing an asset over a service life,
But when you consider the total cost of utilizing an asset over a service life,

there are justifications for alternative patterns of depreciation,
there are justifications for alternative patterns of depreciation,

which gives rise to these other methods that will be considered and
which gives rise to these other methods that will be considered and

looked at in subsequent modules.
looked at in subsequent modules.

In this case, accelerated depreciation was a better choice.
In this case, accelerated depreciation was a better choice.

Professional judgement must be applied in selecting the method we use.
Professional judgement must be applied in selecting the method we use.

There are almost an infinite number of scenarios.
There are almost an infinite number of scenarios.

Accountants must weigh many variables to determine the prefered choice
Accountants must weigh many variables to determine the prefered choice

under any given circumstance.
under any given circumstance.

Let's move on and consider some terminology.
Let's move on and consider some terminology.

This terminology because very important as we move forward and consider depreciation.
This terminology because very important as we move forward and consider depreciation.

First of all, the cost of an asset,
First of all, the cost of an asset,

that's the dollar amount assigned to a particular asset.
that's the dollar amount assigned to a particular asset.

Remember the earlier modules where we talked about what costs are appropriately
Remember the earlier modules where we talked about what costs are appropriately

capitalized and what costs or not?
capitalized and what costs or not?

So now we have the total cost assigned to an asset.
So now we have the total cost assigned to an asset.

It's an ordinary and necessary amount expended to get an asset in place and
It's an ordinary and necessary amount expended to get an asset in place and

in condition for its intended use.
in condition for its intended use.

The service life is the useful life of an asset.
The service life is the useful life of an asset.

It usually relates to the anticipated period of productive use.
It usually relates to the anticipated period of productive use.

And salvage value is the amount expected to be realized at the end of
And salvage value is the amount expected to be realized at the end of

the service life.
the service life.

The anticipated future sales price for used equipment, for example,
The anticipated future sales price for used equipment, for example,

is called the residual or salvage value.
is called the residual or salvage value.

Depreciable Base, it's the cost minus the salvage value.
Depreciable Base, it's the cost minus the salvage value.

That's the cost that we're gonna allocate over the service life,
That's the cost that we're gonna allocate over the service life,

the amount to be depreciated.
the amount to be depreciated.

Book Value or Net Book Value, that's the balance sheet amount that reveals the cost
Book Value or Net Book Value, that's the balance sheet amount that reveals the cost

minus the accumulated depreciation.
minus the accumulated depreciation.

Here's an example,
Here's an example,

here we have the cost of an asset found on the balance sheet for buildings,
here we have the cost of an asset found on the balance sheet for buildings,

less the accumulated depreciation gives us the book value or net book value.
less the accumulated depreciation gives us the book value or net book value.

In terms of service life we don't see it on the face of the balance sheet but
In terms of service life we don't see it on the face of the balance sheet but

typically footnotes will disclose the service life.
typically footnotes will disclose the service life.

In this case let's assume it has a 20 year service life.
In this case let's assume it has a 20 year service life.

The salvage value may not be disclosed at all.
The salvage value may not be disclosed at all.

It's used in the calculations but
It's used in the calculations but

you may not be able to identify it in the financial statements at all.
you may not be able to identify it in the financial statements at all.

Let's assume it's $300,000 in this particular case.
Let's assume it's $300,000 in this particular case.

And the depreciable base would be the cost
And the depreciable base would be the cost

of 2 million 3 minus the $300,000 salvage value.
of 2 million 3 minus the $300,000 salvage value.

So we have a $2 million depreciable base in this particular example.
So we have a $2 million depreciable base in this particular example.

Now as we close this example, I want to ask a question.
Now as we close this example, I want to ask a question.

Can you, from the information, determine, say,
Can you, from the information, determine, say,

how old the asset is at this balance sheet date?
how old the asset is at this balance sheet date?

We had our $2,300,000 asset.
We had our $2,300,000 asset.

It had $300,000 of salvage value so we had a $2,000,000 depreciable base and
It had $300,000 of salvage value so we had a $2,000,000 depreciable base and

we were given a service life of 20 years.
we were given a service life of 20 years.

That means the annual depreciation is $100,000 per year assuming straight
That means the annual depreciation is $100,000 per year assuming straight

line of course.
line of course.

And we had in the accumulated depreciation $1,500,000.
And we had in the accumulated depreciation $1,500,000.

So we know there's $100,000 a year for
So we know there's $100,000 a year for

15 years to come up to $1.5, so the asset is 15 years old in that case.
15 years to come up to $1.5, so the asset is 15 years old in that case.

So you can actually glean that type of information by looking at the balance
So you can actually glean that type of information by looking at the balance

sheet disclosure relative to the cost of the asset.
sheet disclosure relative to the cost of the asset.

And its accumulated depreciation,
And its accumulated depreciation,

you can pretty good estimation of how old
you can pretty good estimation of how old

a business's particular assets are.
a business's particular assets are.