Okay. Today we’re going to talk
about property, plant and equipment, also called fixed assets,
plant assets, operating assets. And these are non-current assets.
Think about your classified balance sheet. Current assets will either convert to cash
or get used up within one year or less. Non-current assets — such as
property, plant and equipment — will take longer than a year to
either convert to cash or get used up. We have three primary categories in
non-current assets: Long-term investments —
and that could be stocks and bonds in other companies that we’re going to hang
onto for a long time; property, plant and equipment; and intangible assets.
Okay. So today we’re going to talk about property, plant and equipment.
And again, goes by a variety of names. These are the most common types of assets
found in the property, plant and equipment account.
Land: Now, land — notice, land does not get depreciated, because land’s going
to be here for an awfully long time. However, everything else is man-made: Buildings;
machines and equipment; computers; vehicles; furniture; fixtures, such as this overhead
projector hanging from our ceiling — which I know you can’t see
— but anything attached to a building, okay, is called a fixture.
Land improvements: Things like fences, parking lots, landscaping, lighting for parking lots.
Okay? Land improvements is also a depreciable asset.
Okay. So these are our primary assets. All of them will have different useful
lives and different salvage values. And when we look at depreciation,
which is one of our main topics today, we’ll see how that plays itself out.
Now, there’s a few things we need to kind of talk about and define,
before we get into actual calculations. First, when we talk about an
asset’s cost, the definition of cost from an accounting standpoint
is all costs that we incur to get the asset ready for its intended use.
This is the amount that’s going to get debited to the fixed asset account,
and we’re going to depreciate this cost over the useful life.
Okay. Now, let’s take land for — as an example. In addition to the purchase price of the land:
Any broker’s fees; any title search costs; any attorney fees; any property
taxes, called delinquent taxes, that the previous owner didn’t
pay, we would have to pay that, that would be included in the cost of the
land. In the event there was an old building that
we wanted to tear down, demolish, remove, and then grade the land and get it ready for
a new building — like our factory, for example
— all those costs of grading and clearing and
demolishing, all those charges get charged to the property, plant and equipment account
— the land account — and that’s
included in our cost. Okay? For a building, in addition
to the purchase price, okay, or the cost to construct it,
we have architect’s fees. Again, we may have broker fees, okay.
If we have to — if we buy an existing building, and we gut the inside of it to reconfigure
it, to serve our purposes better, all those
costs get included in the cost of building —
the amount we debit to the building account — and then we depreciate that amount.
For machines and equipment: Any sales tax; any shipping costs to get it to our place
of business; if we have to bolt it down to the ground; if we have to modify it —
if we have to weld some parts onto it so it’s doing what we want it to do —
all those costs — including testing, to make sure the machine’s running properly —
all those costs get included in the cost of the land, the —
excuse me, the machine, and that’s what gets debited
to that account, and then it gets depreciated. We’re going to look at three methods.
I just want to check, briefly, in case I skipped a slide there.
Okay. This thing advances pretty quickly. We’re going to look at three
different depreciation methods. There are a few others, but given that
this is a financial accounting class and it’s not an advanced accounting class,
we’re simply going to look at straight-line —
which is by far the most popular method, and the easiest method.
We’ll look at the units of activity method and the double declining
balance method, for depreciation. Okay. We’re going to do examples
for all three of these. Okay. This is the slide I’m looking for.
Some useful definitions, which I would like for you to know: First,
depreciable cost equals cost less salvage value.
Okay. Now our — some salvage value, sometimes called residual value —
this is what we think we’re going to recover at
the end of the asset’s life, when we sell it.
Okay. What are we going to salvage, recover. Okay. So cost minus salvage value: This is
the amount of the cost that we’re actually —
we’re not going to recover the difference, and that’s going to get depreciated —
we’re going to spread out that cost, allocate it over the years
that we’re going to use this asset. So that’s the depreciable cost.
Don’t confuse that with the book value — and notice, I’m going to abbreviate book value
BV. We also sometimes call book value
carry value, or carrying value. And this is cost minus accumulated
depreciation: The value of the asset that we have to report on the balance sheet.
We call this the net book value: Cost, minus the amount of depreciation we’ve reported
in all previous periods, since we purchased the asset.
Okay? So each year, accumulated depreciation gets higher and higher, more and more.
It accumulates — hence the name. And as accumulated depreciation
increases, the book value of the asset — which is the undepreciated
portion of the cost — goes down. Okay? Notice: Depreciation is how we
allocate or spread out or distribute the cost of an asset over its useful life.
And we’re doing this, because we have to follow the matching principle —
or the magic concept — remember, accrual accounting, two basic rules:
Revenue recognition and the matching principle. How do we recognize expenses?
And what do we do? We match them to the same time period that
they relate to the revenues they help to generate.
So we can measure revenues and expenses for each
time period, under accrual accounting rules. Notice: It does not try to determine
this piece of equipment’s market value. We’ll determine market value, when
we sell this asset down the year, and we will see an example of that.
Notice: We cannot depreciate an asset below its salvage value, since this is the amount
that we expect to recover at the end of the asset’s useful life.
And that’s a hard-and-fast rule: We cannot depreciate an asset below salvage.
So the book value can never go below salvage value.
And I’m going to show you an example of what happens,
if we do it, and how do we correct that. Okay. So these are useful definitions that
you would be wise to commit to memory — for exam purposes, if nothing else.
Okay. Now we’re going to look at some depreciation examples.
And for all of these examples that we’re going to see today,
we’re going to base them on this information. Here’s our data: The cost of a truck, 130,000
— this is a big 18-wheeler, okay, with a big,
strong engine in there, hauling heavy, heavy goods.
We estimate that we’re going to have this thing — the asset useful life —
for about five years, and we’re going to drive it about 200,000 miles.
And at the end of the five years and 200,000 miles, we think we’re going to be able
to sell it for about $20,000, so we call this the salvage or residual value.
Now notice, the cost — and we talked about cost a moment ago, all costs we incurred
to get this truck ready for its intended use — that’s a hard number.
We know exactly what that number is. Salvage value and estimated useful life are
estimates, which means they may not be exact. And that’s okay.
We’ll deal with those estimates, and the difference
between estimates and actual, down the road. Okay? Now, I’m also giving you the number
of miles this truck was driven each year, because we’re going to need this
information for the units of activity method, and we’ll refer back to this, okay —
year one, two, three, four and five. Okay. These are the actual miles we drove.
We estimated about 200,000. If you were to add those up, you’d see
that we actually drove it a little bit more than we estimated, and that’s fine.
And bear in mind, even though I estimate five years and 200,000 miles,
if I want to hang onto this for six, seven, eight years, I can do that.
It’s my truck. If I want to sell it after two or
three years, I can do that, as well. If I can find someone who’ll
buy this thing for 30,000, even though I estimated 20,000
salvage, I will sell it for 30,000. On the other hand, I may only get $12,000,
because the condition’s not as good. Okay. So again, these are estimates.
They will not be right on the money, and that’s not a problem.
We deal with that in accounting. Okay. So here’s the first method: The
straight-line depreciation method — which I’ll abbreviate SL — and the
formula — which you need to know — is cost minus salvage value,
divided by the useful life. Now, the cost of our equipment was 130,000
— okay, so 130,000 minus the salvage value of
20,000, divided by five-year useful life. This gives us $22,000 of
depreciation expense per year. Okay? Right on your slide there:
$22,000 depreciation expense per year. If I need to have monthly depreciation,
I simply divide that by 12 months. If I want quarterly depreciation,
I divide it by four. The journal entry to record depreciation for
any time period — month, quarter, year — using any method — straight-line, units
of activity, double declining balance — is always: Debit depreciation expense — in
this case, if it’s annual depreciation, for 22,000,
and that goes on the income statement, that’s an
expense; credit accumulated depreciation 22,000, which we said was a contra asset
that goes on the balance sheet. And I’m going to put two
T accounts on the board. Here’s property, plant and equipment.
Remember, we always record at cost all those costs we incurred: 130,000.
And right next to it is my accumulated depreciation account.
And here’s my depreciation for Year 1. Okay, now let’s go back for a moment.
Using this asset, let’s go back to our previous definitions.
My depreciable cost — which we said was cost minus salvage —
would be 130 minus 20, which is $110,000. And what we’re going to do, I’m going to erase
this up here, since it’s on your slide — is, I’m going to put up a timeline
here: 1, 2, 3, 4 — 1, 2, 3, 4, 5 years. And notice, each year I’m
going to depreciate $22,000. So I’m not going to record
an expense all Year 1. We capitalize these assets.
In other words, capitalize means we put it on the balance sheet, and then we spread
out that cost — we depreciate it — over its useful life.
That’s the matching concept. So instead of recording expense all in
Year 1, or all at the end, in Year 5, we divide the depreciable cost — cost minus
salvage, 110,000 — divided by five years. And each year we depreciate $22,000.
Okay? And again, the journal entry to record depreciation is always:
Debit depreciation expense, credit accumulated. Notice: This is an adjusting journal entry.
Depreciation expense gets closed out at the end
of the year, because it’s a temporary account. Remember, we said in a previous lecture,
an adjusting journal entry will have one income statement account and one balance sheet account.
We have that. Depreciation expense goes
on the income statement. Accumulated depreciation — which we said
was a contra asset — that goes on the balance sheet.
Now, a contra asset — just to refresh your memory — has a normal credit balance,
because it’s opposite — contra — to an asset. And we know that an asset
has a normal debit balance. And we subtract the balance that
accumulated depreciation from the cost, and that gives us our book value.
So on the balance sheet, at the end of Year 1,
December 31st, my book value that I have to put
on the balance sheet is 130 minus 22, or $108,000.
Each year, I’m going to record these same journal entries.
Let’s just take a look at what this is going to look like in our general ledger.
End of Year 2 — I’ll put 12/31/02 here — here’s Year 1 and Year 2 depreciation.
At the end of Year 2, we have 44,000 in accumulated depreciation.
Okay. Therefore, my book value of 130 minus 44 — if my math is correct —
book value is $86,000, at the end of Year 2, December 31st.
Year 3, same thing. I now have — at 12/31/03, 66,000 in
accumulated, and my book value is going to continue to go down: 130 minus 66,000
would give us a book value of 64,000. Year 4. Accumulated at 88,000.
And remember that number after Year 4. We’re going to come back to that
particular number for another example. My book value at December 31st, ’04,
130 minus 88, would give me 42,000. And then Year 5 — and the Year 5,
end of the estimated useful life, notice that my accumulated depreciation is
110,000, and my book value — 130 minus 110 —
is 20,000, which is also my salvage value. We are not allowed to depreciate
an asset below salvage value. Remember that.
Do not depreciate an asset below its estimated salvage value,
since that’s the amount we think we’re going to recover, at the end of the useful life.
Okay. Those are the roles of GAAP, so we have to follow those.
Okay. So, straight line depreciation: Cost minus salvage, divided by useful life,
gives me annual depreciation expense. Again, all you got to do is divide by 12,
if I want to do this on a monthly basis. Okay? I’m going to record
22,000 each year for five years. And on my balance sheet, I record fixed assets
at their book value, at the end of each year. Okay? And we can figure this
out, by creating T accounts and showing how the accumulated
depreciation account keeps increasing, and our book value keeps going down.
Pretty straightforward. Okay. Now we’re going to look at the units
of activity method, so I’m going to erase this data.
All right. And we’re not spreading out
depreciation over time. Instead, we’re saying we’re going to drive
this thing, we estimate, 200,000 miles over its
life. And so, what we’re going to do —
and notice the formula, here it is — well, I’m going to point
to it — the numerator — cost minus salvage, 130 minus
20, stays the same. But the denominator, okay,
underneath, instead of using five years, we’re going to use 200,000 miles.
And so, on your slide, 130 minus 20, divided by 200,000 miles, gives us 58 — excuse me
— 55 cents depreciation expense for
each mile driven — per mile driven. Okay? We’re going to use that 55 cents per
mile driven to calculate depreciation for each
year. Now, let’s go ahead and take
a look at our schedule here. So, Year 1 we drove 35,000 miles.
For each mile I drive, I depreciate 55 cents. So in Year 1, my adjusting journal entry
at Year 1 is debit depreciation expense, credit accumulated depreciation, 19,250. Okay? And then notice: Year-end book value
— cost minus accumulated, 130 minus
19,250 — book value is 100,750. Year 2 we drove 50,000 miles,
so we have more depreciation. The journal entry: Debit depreciation
expense 27,500, credit accumulated 27,500. That’s the journal entry.
This schedule is going to show you the value at the end of two years,
so don’t make that — don’t make that mistake. Okay? What you’re looking at on the
schedule is not the journal entries. The journal entry — remember,
debits always have to equal credits. Debit depreciation expense
27,500, credit accumulated 27,500. Our accumulated depreciation, at the
end of Year 2 — 12/31/02 — is 46,750. And then our book value — cost of
130 minus accumulated of 46,750 — book value 83,250 at the end of Year 1.
Okay. Year 3. Multiply 48,000 miles — the
miles we drove — times 55 cents. We get depreciation of 26,400.
Journal entry: Debit depreciation expense 26,400, credit accumulated 26,400.
The accumulated depreciation account, at the end of December 31st,
’03, now has a balance of 73,150. Therefore, my book value — 130 cost
minus 73,150 — book value 56,850. Year 4, 45,000 times 55 cents, 24,750.
Okay. Journal entry: Depreciation expense accumulated, 24,750.
Accumulated now has 97,900 at 12/31/04. Book value at the end of the fourth
year, 32,100 — 130 minus 97,900. Now, watch what happens.
This is where you have to be careful with this method and the next method —
the double declining balance method. In Year 5, when I — I drove 37,000 miles.
I multiply that times 55 cents, and that gives me 26 thou — excuse me — 20,625.
If I add that to my accumulated — 20,625 —
that’s going to give me a balance of 118,525. When I subtract 118,525 from cost, my book
value will be 11,475, which is below salvage value.
I can’t do that, so I can’t use this calculation.
I’m going to cross this out. Just cross this out, like this.
Okay? And so, instead, I have to look at my accumulated depreciation account —
and this is something you have to be — you have to think about.
You have to say, okay, I learned this. I just have to remember, as we
get later on in the asset’s life, I may not be able to use
the full, calculated amount. If my accumulated depreciation is
97,900, and I know that my salvage is 20, and I can’t depreciate book value below 20,
then the amount of depreciation I can take is the number that’s going
to make my accumulated depreciation equal $110,000,
because 130 cost minus 110, book value 20 equals salvage.
So the difference between 97,900 and 110,000 is 12,100.
That’s on your schedule in — highlighted in red — red lettering.
That’s the amount of depreciation I can take in Year 5.
Debit depreciation expense, credit accumulated, 12,100.
That will make my accumulated depreciation 110 and my book value 20,000.
Book value now equals salvage value. No more depreciation.
We can continue to drive this truck for as long as we want.
It’s our truck. We own it.
We simply cannot record any more depreciation, because we have what’s called
a fully-depreciated asset. Okay? So, on your own, take
a look at that schedule, and hopefully you can construct these
numbers and then make some sense out of them. We’re going to move on to the next method,
and that’s the double declining balance method.
This method’s a little bit tricky. I’m going to erase this — these numbers here. Okay. Again, same data.
Now, with the double declining balance method — and notice on the bottom it says,
this is referred to as an accelerated depreciation method,
because it allows more depreciation expense to be recorded in the early years,
and then less depreciation expense in the later years.
Okay? And notice right above that. This is the only method in which we do
not subtract salvage value from the cost, to determine depreciation expense.
I’ll show you what I’m talking about. One of the most common mistakes
students make on the exam, take note. Okay. Three steps, before we
start recording depreciation. First: Calculate what we call
the straight-line percentage. One, which — and the way we calculate it
is one divided by whatever our useful life is in
years. Now, in our example, the truck we
estimated was a five-year asset. So one divided by five equals 20%.
Go ahead. Do it on your calculator. Confirm that.
One divided by five years, we would depreciate 20% each year, using the straight-line method.
Step 2: Double the straight-line percentage, and that’ll give us what we call the
double declining balance percentage, which in this case would be 40%.
Okay? Each year, we’re going to record 40% depreciation,
based on the beginning book value of the asset. And I’m going to show you the calculation
next. Step 3: Multiply the beginning-of-the-year
book value times the double declining balance percentage — which in this case is 40%.
Okay? So we’re going to put these three steps into action, okay.
And just bear in mind that this is the only method which we are not going
to subtract salvage from cost, in the beginning, in order to calculate what
our depreciation expense is. Okay, here we go.
Again, same data. Cost 130, salvage 20, five-year life.
Straight-line percentage, first step, one divided by five, 20%.
Second step: Double that, so the double declining balance is 20 times 2, or 40%.
Now, look at the schedule that we set up here. This is similar, but not exact, to the
previous schedule, for units of activity, because in this schedule, I’m
putting beginning book value, because that’s an important number that we
need. We didn’t need that for the previous methods.
We do need it for this method. Okay. Now, book value we know is
cost minus accumulated depreciation. Well, at the beginning of
Year 1, if we bought this on January 1st, cost minus zero equals cost.
So beginning book value, in Year 1, is our cost of 130.
I’m going to multiply that times 40%, and my first-year depreciation is $52,000.
Debit depreciation expense, credit accumulated, 52.
Remember, debits equal credits. Okay? So at the end of Year 1, on
the balance sheet, my book value — 130 minus 52 — book value 78,000.
Now, remember what we said about balance sheet accounts.
When the clock strikes midnight on December 31st, the end-of-year balances convert
into the following year’s beginning-year balances.
So my December 31st, Year 1, ending balance is
now my January 1st, Year 2, beginning balance. And there it is on the schedule: 78,000.
I’m going to take 40% of that number — 78,000 times 40 —
and my depreciation expense in Year 2 is 31,200. Debit depreciation expense,
credit accumulated, 31,200. Accumulated depreciation in the general
ledger now has a balance of 83,400, 12/31/02. And
my book value at the end of the Year 2, December 31st, is 46,800 — 130 minus 83,400.
Okay. Last year’s ending book value, beginning of next year’s beginning book value:
46,800 times 40%, depreciation in Year 3, 14,040.
So I’m going to put that in my accumulated. Okay, remember, end of Year 3,
debit depreciation expense, credit accumulated, 14,040.
In the general ledger, my balance — 97,000 — whoops, I think I made a mistake up here.
This is — sorry. This is 200.
Now this would be 240, at 12/31/03. Okay. Book value, end of Year 3:
Cost 130 minus 97,240, 32,760. With the double declining balance method,
same with units of activity, we got to be careful
— in later years, we’re not going to be
able to take the full calculated amount. And we’re going to see that next.
So if my ending balance at the end of Year 3
is 32,750, that’s my beginning balance, Year 4.
32,760 times 40% is 13,104. Okay. Now, if I added 13,104 to accumulated,
that would give me a balance of 110,344. And if I subtracted this from cost,
my book value would be 19,656, which again is below 20,000 salvage.
I can’t do that. So I cannot record this full amount.
And what I got to do is the same thing we did last time.
I know that when accumulated hits 110, my book value would be 20,000 — 130 minus 110.
Got to know those definitions. So, 97,240 plus X — whatever that
number may be — has to equal 110. This number here has to stop
at 110 on December, ’04. And so, my depreciation — it’s
in red — can only be 12,760. I can’t take the full calculated amount.
Because now, 97,240 plus 12,760 equals 110, okay,
and simply the difference between these two numbers.
And that’s the depreciation expense I record, in Year 4.
Okay? Notice: Year 5, we cannot record any depreciation expense.
Even though we’re driving the truck, it is fully depreciated.
We ran out of depreciation. And in Year 5 — now, we don’t record zero.
We simply don’t record depreciation. And again, we may own this
truck for another year or two. But we can’t — cannot record
any more depreciation expense. It’s a fully-depreciated asset.
And so, with units of activity method and with the double declining balance method —
especially if you have a large salvage value —
you’re going to run out of depreciation pretty quickly.
You have to be careful. Sometimes you’ll run out Year 3.
So you simply have to be aware of this issue, related to these two depreciation methods.
Okay. So we’ve looked at all three methods, now, and on your own time you can review them,
hopefully make some sense out of it. Okay. But this is a big area within
property, plant and equipment. Onward. Here’s a good graph illustrating
the three different depreciation methods. Notice: Straight line depreciation,
each year I’m recording the same amount. That’s that red line.
That’s what we call straight line. The vertical axis is dollars of depreciation.
The horizontal axis is time passed. Each year, straight line,
we record the same amount. The green line — whatever that color might
be — that’s the units of activity, okay, because as we do more or less
driving, the depreciation expense that year is directly correlated
with the amount of driving we do. We drive more that year, we
record more depreciation. If we drive less miles that
year, we record less. So the green one — that kind of a zigzag
one — that’s for units of activity. And then the declining balance method, which
we called the accelerated depreciation method, we record more depreciation in Year
1, less in Year 2, less in Year 3, etc. If you look at your schedules, you will
see how these graphs illustrate the numbers. Okay? And so, a company can choose whichever
method it wants, to record depreciation. Conceptually, the method we
choose should kind of match or mirror how we’re actually
going to use the asset. If it’s a building, probably straight line.
If it’s a machine — like construction equipment, they get heavy usage —
perhaps units of activity or the declining balance method.
But again, it’s up to each company. And in reality, straight line is by far
the most common, because it’s simple. Okay. Now, in the United States, we are allowed
to use a different depreciation method for tax reporting purposes.
This is not a tax class. We’re not going to go into it.
I simply want to mention it. And we call it MACRS — Modified
Accelerated Cost Recovery System. For those history buffs out there, go back
to the ’80s and the Ronald Reagan presidential
era, when the ACRS program first arise —
arose; and then a few years later they modified the ACRS program.
ACRS was Accelerated Cost Recovery. And then they modified it, and that’s where
we stand, at the time we’re recording this lecture:
Modified Accelerated Cost Recovery System. We use it for tax purposes, and it may produce
a different number than the method we’re using for financial reporting purposes, when
we prepare our financial statement. That’s — we’re going to stick
with those three methods. We’re not going to go into this at all.
Simply mentioning it. You should be aware that
we use it for tax purposes. You will see it more in an
advanced accounting class, or most likely in your tax
class, if you take a tax class. Okay. That brings us to some smaller
issues, which I want to talk about, and that’s partial period depreciation. I’ll leave this up here for now.
If we buy an asset — or sell an asset, for that matter —
midyear, any time other than January 1st or December 31st, we have to calculate depreciation
for those months that we owned the asset. Now, let me give you an example.
If we bought an asset on April 1st, okay, then
we owned it April, May, June, July, August, September, October, November, December
— we owned it for nine months — we would have to calculate
nine months’ depreciation. If we sold an asset on April 1st, we owned
it for January, February and March — we did not own it April through December —
we would report three months’ depreciation in the year of sale.
So it’ll differ, depending on when we bought it, when we sold it.
So we call this partial-period depreciation. Using the same previous data, if we bought
the asset on April 1st — instead of January 1st
— we would have to record nine
months’ depreciation. So I use the exact same formula
for straight-line — cost minus salvage, divided by five
years — and I take that number — which you remember is 22,000 — and
I multiply that times 9 over 12. Or, what you could do is you could take 22,000
annual depreciation, divide it by 12 months —
that’s monthly depreciation — and then multiply it by nine months.
Same thing. And your depreciation in
Year 1 would be $16,500. Okay. That would be your journal entry.
Year 2 would be the full 22,000 depreciation. Okay? But in year of purchase, year of sale,
you might have a partial period calculation. Notice: We would do this with the double
declining balance method, as well, and that would affect each
subsequent year’s calculations. You have to be careful with that method.
I think in the homework you may see that. But notice, units of activity is not
based on time, but actual activity, so it does not affect the calculation for
units of activity method, if we buy it midyear. But it would affect depreciation
Year 1, for straight-line method and for the double declining balance method.
Okay. Revised depreciation. Estimates, like salvage value and
the useful life, can be changed, if the business environment changes.
For example, if we decide to keep a vehicle a
few more years longer than originally expected, due to a bad economy or a
slowdown in our business — business has just not been
very good the last few years, whatever — we can change these estimates.
And we call this revised depreciation, and there’s a specific formula, and it makes sense.
But let’s just take a look at it, and then we’ll apply it.
Formula to calculate revised depreciation equals current book value —
which we know is cost minus accumulated, at the point in time in which we’re going
to change the remaining salvage or useful life
— current book value, at that point in time, minus our new estimate for salvage value
— it can go up or it can go down — divided by the new remaining useful life.
And here’s where you have to be careful, because depending upon what example you’re looking
at, they may give you the original years and
then the new estimate for total life, or they may simply say, these
are the remaining years. You have to be careful in
how you read the information. Okay. So we’re going to take a
look at an example, to apply this. So, new remaining useful
life is our denominator. Okay. Using the same data — cost 130,
salvage 20, original useful life five years. If, after the fourth year, okay, until after
the fourth year, here’s accumulated depreciation.
Okay. 22,000 annual depreciation times four years, we would have 88,000
in accumulated depreciation, after the end of four years.
Which means our current book value would be cost of 130 minus 88,
and that would give us a current book value of $42,000.
We estimate that we’re going to keep this asset for two more years —
since business is slow, we can’t afford to buy a new truck —
and that would give it a total life of seven years —
five, the original, plus two more years. So, the remaining life is seven minus
the four years we’ve already used it. So we have a three-year new remaining life.
And because we’re going to hang onto this truck
for two more years and drive it two more years, instead of the salvage of 20, we’re going
to decrease the salvage value to $10,000. That make sense.
Okay. So, our new or revised depreciation: Current book value 42,000, minus the new salvage
of 10,000, divided by the new remaining useful life of three years, gives us depreciation
for this year and the remaining two years of 10,667.
Debit depreciation expense, credit accumulated. Okay? And that’s our new depreciation
for the remaining life — three years. Notice estimates can go higher
or lower, longer or shorter. It just depends on what you think you’re
going to do with a particular asset. Okay. And for revisions of depreciation,
we’ll assume straight-line depreciation for — to keep it simple.
Okay. I’ve mentioned this a few times, but depreciation is not trying
to determine market value. It’s simply allocating or
spreading out the cost. When we sell this asset — and when we
sell it is whenever we decide to sell it — could be at the end of five
years, could’ve been four years, could’ve been seven years
— it’s really up to us. When we dispose of the asset, that’s
when we’re going to try to get as much as we possibly can — unless we trade it
in and we don’t feel like private sale. But whatever we get, that’s going to really
approximate market value, and then we’re going to determine whether or not we have
a loss on sale or a gain on sale. And so, what we’re going to do is we’re going
to compare what we call the cash proceeds to what our current remaining book value
is, to determine gain or loss on sale. We are not going to talk about exchanging
one piece of equipment for another. That creates a lot of other
issues that you would deal with in a more advanced accounting class.
We’re simply going to assume that we’re selling this for cash,
or we’re simply just giving it away. We’re just putting it in the back of
the yard and let it sit there forever. Okay. After four years of use, accumulated
is 88,000, book value would therefore be 42,000.
If I can sell this truck for 55,000, I would debit cash for 55.
Now, when you sell an asset, you have to take it
off your records, since you no longer have it.
And you don’t want to report these assets on
your balance sheet, if you don’t own them. That’s fraudulent.
So I have to credit property, plant and equipment,
to show that I no longer have this asset. Okay? So I credit property,
plant and equipment for 130. If I don’t have the equipment — remember,
the only time you ever have accumulated is with equipment — or property, plant and
equipment — so I’m going to debit accumulated, simply to zero out the account — get rid
of it. And then notice: If you were to add up
your debits — 55 plus 88 gives you 143 — I only have a credit of 130, I would
have what’s called a gain on sale, because my book value is
42,000, when I sold the asset. But because I maintained good care of
the truck, I was able to recover 55,000. Okay? And so I’m going to report, on my
income statement, in the other revenues and expense section — which comes below
operating income — a gain on sale of 13. Notice that the gain on sale is
a credit, which is like revenue. Right? Revenue is a credit
that increases our income. Okay. If we had sold this asset for less
than book value, we would have a loss. Notice at the bottom of the slide: To determine
gain or loss on sale, compare the proceeds —
which is the cash received — to the book value.
If the proceeds are more than the book value, we have a gain.
If the proceeds are less than the book value, we would have a loss.
Here’s our loss example. We only got 24 instead of 55.
Debit cash 24 — same thing — credit property and equipment for 130, debit accumulated.
And then, to make the journal entry balance, I
have a loss on sale of 18, which, by the way, is the difference between the proceeds of
24 and the book value of 42,000 at the time of sale.
I lost 18,000. Okay? And again, notice a loss on sale is
a debit, which is just like an expense. It reduces income.
Last comment — and I don’t have a slide for this — but simply, if I just put this truck
— I drove it or pushed it into the back of the
yard there, and it’s going to sit for the rest
of eternity, and it had a book value of 42, but it was just —
it was just spent, it was just useless — I would put loss on disposal, 42,000,
because I wasn’t able to recover anything for it.
Had a book value of 42, and I’m simply going to park it in the back of the yard there.
Loss on disposal, 42,000. I didn’t receive any cash.
Okay? Okay. Last couple of items here.
We have three ratios, and the ratios are related.
Okay, we have the asset turnover ratio, the profit margin ratio —
which we’ve previously seen — and we have return on assets,
sometimes called return on investment, or ROI.
So ROA, return on assets, ROI, return on investment.
We’ll stick with ROA. Let’s assume the following
information: Net sales, 2 million. Let’s think back for a moment.
Net sales: Sales minus sales discounts, minus sales returns and allowances, equals net sales.
Right? Net sales, 2 million. Net income, 400,000.
And we need to know the beginning of the year value for our long-term assets
or total assets — we’ll use total assets, in this case.
Different books sometimes calculate ratios a little bit differently.
We’ll stick with whatever is in our book. So January 1st, we had 400,000 in assets.
End of the year, December 31st, we had 600,000 in assets.
So we want to use a number called average assets.
How do we get average in any ratio? We take the beginning-of-the-year balance,
plus the end-of-the-year balance, and we divide by two.
And it gives us a rough average. So, average assets would be 400 plus 600,
divided by two, or 500,000 average assets. Now let’s look at these ratios, and
we’ll talk about what they represent. Okay. The asset turnover ratio — 200,000
net sales, divided by average assets of 500. And what this is telling us is for
each $1, okay, we have a ratio of four over one for the asset turnover ratio.
For each $1 that we invested in assets, we were able to generate $4 revenue.
Now let me give you something to compare it to, so you can think about this.
I have two different car companies — automotive companies.
They both have a billion-dollar factory. One factory runs one shift
a day, five days a week. The other factory runs two
shifts a day, six days a week. They both have a billion-dollar factory, but
this factory is producing a lot more cars, and therefore a lot more revenue.
It’s a more productive asset. So this is a measure of productivity,
for assets that we’ve invested in. Have we made good decisions to invest
in assets and get maximum utilization, or are they sitting idle, too much of the
time? So asset turnover ratio says for
each dollar we invest in assets, how much revenue are we going to generate?
Profit margin, which we’ve previously seen, is net income divided by net sales.
Okay? So in this case, 400,000 divided by 2 million is .2, or 20% over 1.
Okay? And what this is saying is for each $1 in
sales or revenue, how much profit do we keep, after tax, at the end of the year?
What goes into our pocket? Okay? And so this is a profitability ratio.
And then, return on assets says, net income, 400,000, divided by average assets of 500,000,
.8 — or .8 over one — is, for each $1 that we invested in our assets,
how much profit do they generate for us — after tax?
Okay. So now notice: If I multiply the asset turnover ratio times the profit margin,
I’m going to get the return on assets. Each $1 invested assets generates $4 revenue.
Each $1 of revenue generates 20 cents of profit. Therefore, each $1 of assets
invested generates 80 cents profit. Notice how net sales — okay — we have
net sales, divided by average assets. Okay. And then we had — what —
net income divided by net sales. Okay. So if we eliminate net sales, we
simply say, return on assets is the result of asset turnover ratio times our profit margin.
Okay? And these are three commonly-used ratios in business,
and you should become familiar with them. Okay. And that’ll do it for
property, plant and equipment.