1. Depreciation
Chapter 22
Accounting II

2. Current v. Long-term Assets
Current Assets – Cash and other assets reasonably expected to be converted to cash or used up (consumed) within one year. (Accounts Receivable, Supplies, Inventory, Prepaid Expenses)
Long-term Assets (also called Plant Assets or Fixed Assets) – Assets used in the business, not reasonably expected to be converted to cash or used up in one year. (Equipment, property, machinery, vehicles.)

3. Assets don’t last forever.
The cost of a long-term asset must be expensed (proportionally) over the time period the asset is used.
There are 3 methods used to pro-rate the cost of an asset over the asset’s “life.”
The 3 methods are: depreciation, amortization, and depletion

4. Depletion
Used for natural resources (timber, minerals, oil, gas, etc.).
E.g., an oil well has a finite life – eventually, all the oil will be pumped out.
The cost of setting up an oil well is spread out over its productive life.

5. Amortization
Used for intangible assets – assets that can’t be physically held (e.g., patents, copyrights, customer lists, software, etc.)
The cost of an intangible asset is spread out over the asset’s useful life. (e.g., most patents are good for about 20 years; copyrights, for 70 years after the death of the author)

6. Depreciation
Used for tangible assets (equipment, machinery, vehicles)
The cost of the asset is prorated over its useful life.

7. Quick Quiz
For each of the following, name the method that would be used to apportion the asset’s cost over its useful life:
A gold mine
A building
A customer list
A truck used for deliveries

8. Answers:
Depletion
Depreciation
Amortization

9. Buying Long-term assets
When a business buys a long-term asset, it is recorded similarly to current assets
Debit the asset (increase) and credit cash or accounts payable.

10. Using Long-term assets
A business buys long-term assets to earn revenue
As the assets are used, and as time passes, they decrease in value (e.g., newer models become available.
For example – cars decrease in value as soon as they are driven off the lot:

11. Long-term assets
All long-term assets have a limited useful life (except land)
To match revenue with expenses used to earn the revenue, a part of an asset’s cost must be “expensed” in each fiscal period that the asset is used to earn revenue.

12. Expensing Long-term assets
Businesses use an account called “Depreciation Expense”
Depreciation Expense – the part of a long-term asset’s cost that is transferred to an expense account each fiscal period over the asset’s useful life.

13. Depreciation
Depreciation expense does not represent the actual decline in value of an asset.
It tries to allocate the asset’s cost over several fiscal periods
Never depreciate below salvage value

14. Calculating Depreciation Expense
You need to know 3 things to calculate depreciation expense:
Original cost of the asset: all costs paid to make the asset useable to the business, including delivery and installation costs;
Estimated salvage value: scrap value or residual value; what you can sell it for when you’re done using it

15. Calculating Depreciation Expense, continued
3. Estimated useful life – the number of years the asset will be used (based on previous experience, and guidelines available from the I.R.S. and trade associations

16. Calculating Useful Life:
Two factors affect a long-term asset’s useful life:
Physical depreciation -- wear and tear on the asset; an asset may deteriorate due to aging and weathering
Functional depreciation – an asset becomes inadequate or obsolete – can no longer perform as needed. Obsolete means a newer machine can operate more efficiently or produce better service

17. Calculating Depreciation Expense
Formula:
Original Cost
- Estimated Salvage Value
Estimated Depreciation Expense (Total for
useful life)

18. Calculating Depreciation Expense (Continued)
To calculate the Depreciation Expense for a fiscal year: Est. Depreciation Expense (Total) ___________________________ Years of Useful Life = Annual Depreciation Expense

19. Straight Line Depreciation
The straight line method of deprectiation charges an equal amount of depreciation expense for a long-term asset, in each year of its useful life

20. Example:
A business buys a piece of machinery that costs $800 plus $20 for installation costs. The estimated salvage value is $100. Original Cost = $820 Minus Estimated salvage value ($100) = Estimated Depreciation Expense (Total) $820 - $100 = $720; useful life is 5 years: $720 / 5 = $144 per year

21. Another Example
A business buys a truck for $30,000. What is its useful life? 5 years It has a salvage value of $15,000. What is the annual depreciation expense, using straight line depreciation? ($30,0000 – 15,000) / 5 = $3,000 /year

22. Recording Depreciation Expense
When you record depreciation, you do not reduce the “book value” of the asset
When you make the adjustment for depreciation, you debit Depreciation Expense and credit a “contra” account – Accumulated Depreciation
A ‘contra’ account reduces the value of a related account

23. Asset Records
Most businesses keep a separate record for each long-term asset.
Sometimes called a “Plant Asset Record.”
Includes the date bought, information about the asset (e.g., model / serial no.) the original cost, estimated useful life, estimated salvage value, book value, and accumulated depreciation.

24. “Book Value”
Book value is what an asset is worth according to the books of the business. It is the difference between original cost and accumulated depreciation.

25. “Basis”
The “basis” of an asset is another name for “original cost” – it includes the original price of the asset, plus shipping and installation and anything else needed to place the asset in service.

26. Recording Depreciation Expense
To record depreciation expense (adjusting entries): Dr. Depreciation Expense Cr. Accumulated Depreciation The book value of the asset does not change when depreciation is recorded.

27. Disposing of Long-Term Assets
When a business can no longer use a long-term asset, it disposes of it by selling it, trading it, or discarding it.

28. Disposing of Long-Term Assets
A journal entry is needed to: (1) remove the asset and its accumulated depreciation from the books; (2) recognize any cash or other (new) assets received for the old asset; and (3) recognize the gain or loss (if there is any) on the disposal of the asset.

29. Recognizing gain or loss
A gain or loss on a sale of a long-term asset is the difference between the value of the asset received and the book value of the asset sold. Value of Asset - Book Value = Gain or Received of Asset sold Loss

30. Example:
A business buys a printer for $820. Its estimated salvage value is $100, so it can depreciate the asset down to $100, and then no further. Total Depreciation = original - salvage value Expense cost $720 = $820 - $100

31. Example, continued
Suppose the printer is sold for $100. Is there a gain or loss on the sale? No, because the business sold it for book value. Gain or Loss = Value of Asset - Book Value Received of Asset sold $0 = $100 - $100

32. Additional Examples
What if the printer was sold for $40? (Remember, book value is $100) You would have a loss on the sale of $60 What if the printer was sold for $120? You would have a gain on the sale of $20

33. Recording the Disposal of the Asset
To record the disposal of the asset, you need to:
Remove the original cost of the asset and its related accumulated depreciation, and
Recognize the cash (or other asset) received

34. Journal Entries:
Before disposing of the printer, the accounts look like this: Printer Accumulated Depreciation $820 $720 Entries to dispose of the printer for $100: Printer Accumulated Depreciation Cash $820 $820 $720 $720 $100

35. Sell asset at a gain:
Before selling the printer for $120: ($100 salvage value)
Printer Accumulated Depreciation
$ $720
Entries to dispose of the printer for $120:
Printer Accumulated Depreciation Cash Gain on Plant
$820 $ $ $ $100
$20
Decrease Increase
Assets

36. Sell asset at a loss:
Before selling the printer for $60: ($100 salvage value)
Printer Accumulated Depreciation
$ $720
Entries to dispose of the printer for $60:
Printer Accumulated Depreciation Cash Loss on Plant
$820 $ $ $ $60
$40
Increase Decrease
Assets

37. Accelerated Depreciation
Most assets do not depreciate the same amount each year. Most assets depreciate / lose value faster in the first few years they are owned, and less in later years.
For these assets, more depreciation should be charged in the early years than the later years

38. Accelerated Depreciation
Declining balance method – multiply the book value (original cost – accumulated depreciation) by the same amount each year – a constant depreciation rate.
Because the book value is the highest in the first year, that year will have the highest depreciation expense.

39. Double Declining Balance Method
A method of accelerated depreciation
The book value declines each year at twice the straight-line rate, multiplied by the book value.

40. Example of DDB method:
If an asset has a useful life of 5 years, it declines 20% per year: (100% / 5 = 20% per year) Using the DDB method, the DDB rate would be 40% per year (20% x 2 = 40%)

41. Original cost: $20,000; useful life: 5 years; Salvage Value: $2,000
Straight-Line Method
Double Declining Balance Method
Year
Beginning
Book
Value
Annual
Deprec.
Ending 1
$20,000
$3,600
$16,400
$8,000
$12,000 2
16,400
3,600
12,800
12,000
4,800
7,200 3
12,600
9,200
2,880
4,320 4
5,600
1,728
2,592 5
2,000
592
Total Depr.
18,000
Original cost: $20,000; useful life: 5 years; Salvage Value: $2,000

42. Comparing Straight Line and DDB Methods of Depreciation
Chart comparing depreciation methods