10. Depreciation

Let's talk about depreciation. Let's first try to figure out why we need depreciation and what its purpose is. So when you have assets with a life, meaning, uh, life means how long can you use it? How long are you gonna be able to use this asset in your business? So if you have assets with a life of longer than one year, you need a way to allocate the cost of the asset. That may not mean anything to you, so let's take a look. Let's say you buy a truck for your business for $20,000, and you know that that truck is gonna last you for 10 years, and at the end of that 10 years it's gonna be worth $0.

So if you bought that truck on January 1, you would say your truck account increased and your cash account decreased. This makes enough sense. We've done this a bunch of times before. There are no expenses here because you haven't used up any of the truck. You haven't incurred any of the expense for the truck. You just swapped assets. You gave them cash, and you got a truck, and you swapped your assets, $20,000 for $20,000, right? But at the end of the 10 years, you've used up the entire truck. The truck is worthless. You've incurred all of the expense for that truck.

So if you've got 10 years, and you say it's $20,000 at Year 0, and then at Year 10 it's worth $0. Well, how are we gonna allocate that cost? How are we gonna go from $20,000 to zero? Well, it's a pretty simple equation. You've got $20,000, and you've got 10 years to get it down to zero. So you end up with $2,000 per year. So we know that every year that we're using the truck, we're incurring a $2,000 expense. And so this becomes, if you bought it on January 1: truck, 20,000; cash, 20,000.

Then on December 31, what you're gonna do is you're gonna take a depreciation expense of this $2,000, and we're gonna put that $2,000 into another account called accumulated depreciation. So you may be thinking to yourself, "Well, I thought we were trying to decrease the amount of the truck so that at Year 10 it was down at zero." Well, that is what we're trying to do, but we don't touch this account directly. This account, the truck account, holds our historical cost at $20,000, and then we have a contra account called accumulated depreciation that holds all of the depreciation expenses that we take.

And if you'll remember from the contra accounts video, contra accounts simply exist to take away from other accounts. So the accumulated depreciation account is a contra asset. So what you end up with on your balance sheet is something like, let's say it was just truck, and then you have accumulated depreciation for truck. Now, generally you'd see assets and accumulated depreciation, and it wouldn't be so specific. But you would have $20,000 truck, then you'd have $2,000 accumulated depreciation, and so the book value of your assets would be $18,000. So in a way it is taking away from the truck account, but we don't adjust it directly.

We adjust the accumulated depreciation account. So again, with the bucket analogy, you've got depreciation expenses going in each year. So Year 1, Year 2, Year 3, you're putting all of these depreciation expenses in. And where are you putting them? You're putting them into accumulated depreciation. So this account just holds all of your depreciation expenses, and its only purpose is to hold these depreciation expenses and offset the value of these assets. That's the only reason it exists. So why do we have to do this? What is the point of doing this? Why don't we just take the expense at Year 0 or take the whole expense at Year 10 even?

And that goes back to the matching principle that we've talked about before, because in Year 5 this truck helped us generate some revenue, presumably, right? It's a business asset, and it helped us do something in our business. So we need to match the expenses and the revenues that they create, right? So we can't literally match, "Well, I drove the truck 10 miles, and it created $100, so let me try to figure out..." So what we do is we take a straight line, and we say, "Okay, reasonably, we can assume $2,000 per year." And that helps us match the expense of using the truck to the useful life that we got out of it.

And we're gonna go over depreciation much more in Chapter 8. We're gonna talk about all different kinds of ways to calculate depreciation. But for now, the only one that you really need to know is straight line, and straight line is a straight line. This is the one that we've been doing here. And just a quick note about straight line: if your teacher says the truck cost $20,000, but at the end of its useful life it's worth $1,000, and the useful life is still 10 years, then you can only depreciate down to $1,000. So at the end of its useful life, if it's worth $1,000, then you only depreciate down to $1,000 because you can't depreciate more if it's still worth a thousand bucks.

So what you do there is you do the acquisition cost minus what it's still going to be worth at the end of its life over its useful life. So in this case, you would have $1,900 per year because at the end of its life you're gonna sell it for $1,000, so you can't incur a $1,000 expense if you're gonna be able to sell it for that $1,000.