Source: Instrumental “Drops of H2O ( The Filtered Water Treatment )" by J.Lang (feat. Airtone),” Creative Commons, http://ccmixter.org/files/djlang59/37792
Hey, everyone, and welcome to our video, today, on depreciation. So what is today's video about? Well, today is going to be all about depreciation. We're going to talk about a few things. We're going to talk about accumulated depreciation. We're also going to talk about different depreciation methods. And we're going to finish up, today, with a discussion of residual value.
But let's start with depreciation of capital assets. What is depreciation? Depreciation is the process of cost allocation to expense of a plant asset, over its useful life. So it's a cost allocation. So what's happening, here, is part of the asset's useful life has been used. So we need to allocate that cost to expense, to recognize that usage of the asset, within our business operations.
So why do we record depreciation? Well, we have these long-term assets-- could be buildings, equipment; whatever the case may be-- and they're used over multiple periods. So we're using these assets to generate revenue, over multiple periods. So we need to allocate that cost, over those multiple usage periods.
So what we're doing, there, is we're matching. So we have the cost of the asset being allocated through depreciation, that cost allocation to expense, as we're receiving the benefit of that asset, in terms of generating revenue. So it helps us achieve the matching principle, matching expenses with our revenue.
And one more thing to consider, under depreciation of capital assets, is land. So what about land? I talked about buildings, equipment, that type of property; but land? Land is not depreciated, because land does not get used up. We have our manufacturing plant on top of land, and we have our office building on top of land, but that land, itself, does not get used, so it does not get depreciated.
Now, let's talk about accumulated depreciation. So what is accumulated depreciation? Accumulated depreciation is the total depreciation expense recorded, to date, in an asset's life. So it's the total depreciation expense. So it's tracking the total of depreciation expense, for that entire asset's life.
Accumulated depreciation classification. So how is accumulated depreciation classified? Well, it's considered a contra asset account. So what does that mean? What does "contra asset" mean? That means accumulated depreciation is an account with a credit balance that follows the asset account that it offsets, on the balance sheet.
So accumulated depreciation has a natural credit balance. As we see in the definition, there, it's an account with a credit balance. And now assets have a natural debit balance. So that's where we get the idea of contra asset. So it's a reduction of our assets.
And another key piece of that definition of contra asset is that it offsets, on the balance sheet. So what does that mean? That means that each depreciable asset will have its own accumulated depreciation account, because we're tracking the total depreciation expense for that asset's life. So that's accumulated depreciation.
Now let's talk about depreciation method. What methods are available to use? Well, there's straight-line depreciation, which is depreciating the asset, equally, over its useful life. And there's also accelerated depreciation methods. And now there are multiple accelerated depreciation methods. Those methods are MACRS and ACRS, double declining balance, sum of the years' digits, and units of production.
So which method is used? One method for reporting, and one method for taxes. So what that means is that, as the business, we're allowed to use one method for reporting-- so when we prepare our financial statements, which the business determines. So the business makes determination of which depreciation method to use, for their financial-reporting purposes. They might choose simplicity and want to just go with straight-line depreciation, or they want something that more accurately reflects the usage of their assets.
So, for reporting, the business can determine which method of depreciation they'd want to use. But, for taxes, we have to use MACRS and ACRS. Now, MACRS is Modified Accelerated Cost Recovery System, and ACRS is Accelerated Cost Recovery System. That's what those acronyms stand for, and that's what we're required to use, for tax purposes. So that's the depreciation method.
Now, let's finish up, today, with a discussion of residual value. Well, what is residual value? Residual value is the fair value of the asset, at the end of its useful life. Now, how do we determine residual value? Well, the owner determines residual value. It's really an estimate, by the owner that purchased that asset, of what the fair value is going to be, at the end of its useful life.
For example, if a company purchased new equipment at a cost of $100,000, and they expect that equipment to last five years, and, at the end of that five years, they might estimate that it's worth $10,000-- so, if they sell it used, they can get $10,000 for that equipment, in five years. That $10,000-- that would be considered the residual value. So residual value and depreciation.
Residual value does impact the depreciation calculation. OK? So we have to take it into consideration, when we're calculating depreciation. And can we depreciate an asset beyond residual value? We can't. So, not only does it factor into our calculation, but it also sets the amount which we cannot depreciate an asset below. So we can't depreciate an asset any farther than its residual value.
So let's summarize what we talked about, today. In a nutshell, today was all about depreciation. We talked about what is depreciation. We looked at the idea of accumulated depreciation. We talked about different depreciation methods that can be used. And then we finished up with a discussion of residual value and how that factors into our depreciation calculation.
I hope everybody enjoyed this video, and I hope to see you next time.
Terms to Know
The process of cost allocation to expense, of a plant asset over its useful life.
The total depreciation expense recorded to date in an asset’s life.
An account with a credit balance that follows the asset account that it offsets on the balance sheet.