3. What is Depreciation?

Before we get into all the depreciation methods, I wanna give you a brief overview about depreciation itself. I wanna talk about what it is and why we have to use it. In accounting, there is a matching principle, and the matching principle says that we have to match the revenues and expenses to the time period that they were incurred or earned. Right? So if we have two years, any expenses we incurred in Year 1, we have to recognize in Year 1, which is why we often have to do adjusting journal entries at 12/31, right? Because we'll have earned some revenue here, but maybe won't receive it until here, or we'll incur an expense here and maybe won't have to pay for it until the next year.

But we always have to recognize those entries at 12/31, because they happened in Year 1. So that's why we do all of those adjusting entries at 12/31, is because of the matching principle. We have to recognize those expenses in Year 1, because we actually incurred them in Year 1. So depreciation is all about the matching principle. And the issue with depreciation is you've got a really long timeline. Let's say, for this example, one, two, three, four, five years. So you've got five years in this example, and you have some asset, you have some piece of equipment that is going to be useful for these five years.

And let's say you pay $100,000 for it here, and then you get to use it for five years. Now, my question is, where should you recognize the expense of $100,000? 'Cause when you buy it, it's really an asset because it has a probable future economic benefit, doesn't it? And that's the definition of an asset. So when you buy it right here at Year 0, you get to use it for the next five years, so it becomes an asset. So that piece of equipment goes into the asset account, and you decrease your cash.

But at the end of Year 5, it's no longer useful. So at the end of Year 5, let's say it's worth $0. So somewhere along the way, you used up this asset, didn't you? It was worth 100, then it was worth zero. So somewhere along the way, you incurred expenses and you should probably be recognizing entries, and that is exactly what depreciation does. Depreciation says you have a dollar amount of $100,000 and a time period of five years, and depending on your method, you're going to depreciate your asset until you get to Year 5. So each period, you're gonna recognize some sort of depreciation expense.

Because what we're basically saying is that for each period, you're using up part of the machine. Because the machine is becoming less and less valuable, and so for each period, you need to recognize an expense so that the value of the machine over time is going down. And it could go down in a straight line, it could go down real fast and then slower, or it could go down like that. And how it decreases depends on what method you're gonna use, and we'll have a video for each method. But how it decreases depends on the method. But there are a couple things that don't change even though you could change the method.

So in this video, I wanna talk about a couple of things that don't change. Now, depreciation is not unlike bad debt expense. With bad debt expense, we said we're gonna put in bad debt expenses into this bucket called allowance for bad debts. With depreciation, we have the same setup. We've got depreciation expense, and we put it into a bucket called accumulated depreciation. This is an expense. This was an expense. This was a contra asset. This served to decrease accounts receivable. This is a contra asset. This serves to decrease whatever the asset account is. It could be equipment. It could be buildings. It can't be land, because we don't depreciate land.

But any depreciable asset, we could have an accumulated depreciation account for. So in the same way that we put bad debt expenses into the allowance, we're putting depreciation expenses into the accumulated depreciation account. And it's all right there in the name, accumulated depreciation. It accumulates depreciation. So if you'll remember, the bad debt expense journal entry looked like bad debt expense, allowance for bad debt. The depreciation journal entry is depreciation expense, accumulated depreciation.

So you can see the concepts are quite similar. We also had this write-off concept. When you write off an account, you take it out of the allowance. We have a similar concept, except it's when you sell the asset at the end of the useful life, you're gonna decrease the accumulated depreciation. We'll get to this in a little bit. The important part for now is that you know that this is always your depreciation journal entry. In the same way that most of our work was determining what is our bad debt expense? Are we gonna use the income statement method? Are we gonna use the balance sheet method?

What's the net credit sales? What's the percentage uncollectible? Most of the work in that chapter went into determining what's the bad debt expense. Similarly, most of the work in this chapter goes into determining what's the depreciation expense? Are we gonna use double declining balance? Are we gonna use straight line? Are we gonna use production units? Most of the work is spent right here, but the upside is once you get depreciation expense, everything else is pretty straightforward. Now, let me talk about two more things that all of the methods we're gonna look at have in common. One is a life, and the other is a salvage value.

The whole purpose of depreciation is to allocate the cost of the asset over the life, right? So I said if it's five years, we're trying to allocate the cost over the entire life of that asset. So you're gonna be given a life of an asset, and a life could either be in years, or it could be in units. So we could say it's a five-year life, or we could say it's something like 10,000 units, and the units could be items produced, it could be hours, like hours that the machine is actually on. These are the two that you're gonna see most often, years and units.

And honestly, it doesn't make that much of a difference what the unit is, if the unit is units or if the unit is years. The concept is the same. We have to allocate the cost over the life. Now, what is this salvage value here? This salvage value is how much can you sell this machine for when its useful life is over. When it's totally used up, how much can you sell it to a junkyard for? How much can you salvage the metal or the parts or the materials for? So if we have an asset where we say it's gonna go from $100,000 down to not useful, but we can sell whatever's left over, we can sell that for $5,000, let's say.

So the amount that we're able to depreciate is not $100,000, it's $95,000. Because we can't depreciate past the salvage value. And the reason is, we know even if it's completely worthless to us, that somewhere it's worth $5,000. It may be completely useless to us, but we can sell it for parts for five grand. So don't ever, ever, ever, never, never, never depreciate beyond the salvage value. Because even if it's worthless, it's not really worthless if it has a salvage value. This number right here, this $95,000, actually has a proper name, and this number is called the depreciable base. How much is able to be depreciated?

How much of this $100,000 are we able to depreciate? How much are we able to recognize as an expense over the life? And as you can see from this little example, the depreciable base is the cost less the salvage value.

So cost minus salvage value gives you the depreciable base. And don't ever, ever, ever forget, you have to include salvage value. That's gonna be an easy way to miss a couple of questions, is if you forget to take into account salvage value. Okay, so before we get into the fun stuff, before we get into the methods, let's go over everything that's common. The first is, this is how you record your depreciation expense. You recognize your expense, and you put it into this contra asset of accumulated depreciation. And this contra asset only serves to take away. So if you have equipment at X, then you have accumulated depreciation on equipment at some Y value.

So this accumulated depreciation, it only serves to take away the depreciation from your purchase price. 'Cause you leave the equipment on your books at the historical cost, and then we adjust the accumulated depreciation as our contra asset. So here's your journal entry, and then you also have a life and a salvage value, because we're trying to allocate the cost over some life, but not over the salvage value. So if the life is five years, we're trying to allocate it over five years, but we never go down past the salvage value. And the amount that we can depreciate, the amount that we are able to depreciate, becomes what's called a depreciable base.

So we can depreciate all of this. This inside this triangle, that's our depreciable base. Because that is the amount that's able to be depreciated, and its formal equation is cost minus salvage value. But if you look at this graph and try to remember this in your head, I think this will help you. You need to put your salvage value bright red line across the bottom here and write a note, "Never go down below that."