Depreciation explained
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- เผยแพร่เมื่อ 21 ก.ค. 2024
- What is depreciation? How to calculate depreciation? Depreciation, amortization and CapEx tutorial. Overview of depreciation accounting (concept and application), and related topics such as accumulated depreciation, book value, residual value, historical cost, fixed assets, amortization, useful life, capital expenditures (CapEx) and capitalization. Intended for students and business people at both entry and advanced levels.
⏱️TIMESTAMPS⏱️
0:00 Introduction
0:20 What is depreciation
1:22 Depreciation definition
2:50 Useful life of an asset
4:05 Accounting for depreciation
4:52 Depreciation journal entries
5:25 Historical cost of an asset
6:20 Straight-line depreciation vs other depreciation methods
7:26 Residual value of an asset
7:55 Depreciation vs amortization
Depreciation is the accounting process of allocating the cost of tangible assets to current expense in a systematic and rational manner in those periods expected to benefit from the use of the asset.
That last part of the sentence “in those periods expected to benefit from the use of the asset” is called the matching principle: expenses should be recorded during the period in which they are incurred.
Depreciation is often referred to as a non-cash expense. The cash was spent when we bought the asset, depreciation allocates the value of the asset over the years in which we use it.
As you can see from the journal entries in the video, depreciation is not about putting money aside for buying a new asset once the current one is at the end of its lifetime. Depreciation takes the amount you spent to buy the asset, and allocates a proportionate amount to each of the periods of its useful life. Hopefully the company that we are looking at generates very profitable products or services with the building, machine and truck that they are using, and the cash generated with selling these products and services can be used in the future to buy replacements for the assets that are at the end of their lifetime.
What can you include in the value of the asset on the balance sheet when you buy it? This depends on the accounting rules that your company applies, which in turn depends on the country where you are located and whether you are accounting for tax or statutory purposes, or for reporting to the stock market. Generally, what you pay for the asset to the supplier, as well as transportation and installation cost can be capitalized. Capitalization means recording things as fixed assets on your balance sheet.
It’s important to have consistency of method in the way you depreciate assets. A company could change from linear depreciation of its trucks to a depreciation based on units of production (which in the case of trucks would be mileage), if that presents a more fair and accurate representation of the value of the assets. However, you can’t be flipping back and forth between methods randomly every year, as that would adversely impact the year-over-year comparisons, and it would not come across as very systematic and rational per our definition earlier on.
What is the difference between depreciation and amortization? The concept is the same, but depreciation and amortization are applied to different types of assets. You depreciate a tangible asset, and amortize an intangible asset. The threshold levels (minimum total spend) and capitalization criteria for intangible assets tend to be a lot more stringent than those for tangible assets.
Related video: CapEx versus OpEx • CapEx vs OpEx explanation
Philip de Vroe (The Finance Storyteller) aims to make strategy, finance and leadership enjoyable and easier to understand. Learn the business vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better stock market investment decisions. Philip delivers training in various formats: TH-cam videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!
If you enjoyed the video, then please subscribe to the channel! Now that you understand how depreciation works, it's time to study CapEx vs OpEx th-cam.com/video/na4jbAh_vkQ/w-d-xo.html and depreciation's "sister" called amortization th-cam.com/video/ci72a_SzFcQ/w-d-xo.html
Holy shit dude, did you just explained this far easily than all the accounting lectures I have ever met in my life?
Wow just wow.
One dount however, what is depreciation allowance?
Thanks for the compliment! :-) I am not completely clear on what depreciation allowance means, as (from a quick Google search) it seems to be used by some people to describe the depreciation expense charge in the P&L, and at other times as the cumulative deprecation on the asset (balance sheet). My best guess: I think depreciation allowance is the same as what I call in the video accumulated depreciation, the sum of the history-to-date deprecation on a contra account on the balance sheet.
Geez, why the hell do we need live Zoom class sessions and school in general when you could get it easily broken down in this video? Thanks, now I get it after all my years in high school and college lol
You're welcome! Happy to help. Please spread the word to friends and colleagues.
Trues up, thanks @storyteller
Not to mention spending hundreds of dollars for a book, that you're barely even going to use.
Thank you very much for explaining the accounting jargon 😊 looking forward to more videos. Thank you once again.
You're welcome, Khalid! Thank you for watching and commenting. My "Accounting 101" playlist might have some more good videos for you: th-cam.com/video/lBvnSgIGVnU/w-d-xo.html Please take a look!
3 hours before a big test and I know more about this topic then the others who payed attention in class.
Well done finding a more efficient way to learn! 😉 Help out your best friends and send them the link to the video for some last minute "boost" to their knowledge.
There is not so many comments that I can see here... but... honestly... without your videos I would never ever understood and finished The Intelligent Investor book... I hope you'll have much more subs in the future! Thank you so much!
Thank you very much, Daniel! That is wonderful to hear. Please spread the word about the channel to friends and colleagues! You can find a lot of my videos in TH-cam Search by typing in the specific finance topic and adding "finance storyteller" after it. Or navigate through my playlist on a specific topic, such as the income statement th-cam.com/video/Hq-44PHgAiU/w-d-xo.html
The Intelligent Investor..... is a fall asleep book for novice investors
@@Brownismyname could you recommend me some books that can make me investor JEDI ? -) I will be very thankful !
@@DanDylan Read Nassim Taleb's "The Black Swan", and "Antifragile"!
Really useful video. Especially at 3:38 which was always a question for me - what happens after the useful life of the asset.
Thank you! Very happy to hear that. :-)
nice video man, gonna watch all your videos to further understand how to read financial statements and to help me in corporate finance, and valuation. Thanks in advance
Great to hear that, Dolev! Here is the link to my playlist of finance case studies, that should help you with each of the financial statements as well as the connection between them: th-cam.com/video/PI9X5Ybek_E/w-d-xo.html
I learn a lot by watching your videos, but it's also a nice treat to read the questions and your answers.
Thank you.
That's great to hear! Yeah, I try to help and explain when people still have questions after watching the videos. 🙂
You explained this so simply!! Thank you very much
You're very welcome, Janine! 🙂
I've watched this. Its very useful. I gave you a like. It explained depreciation concept as element of finance analysis of an asset. The element is *the value of the asset* after being purchased and used. Alas, I am still wondering why we need depreciation analysis and how it benefits us. 7.5/10 video (Y)
Thank you for the feedback, Jay! This was one of my earliest videos, I have made many since then. Maybe you can watch the ones on EBIT-EBITA-EBITDA th-cam.com/video/nImp51zYcy4/w-d-xo.html for some context, as well as my analysis of how "big" depreciation and amortization are for the DJIA30 companies th-cam.com/video/8SvZ3IAuPL8/w-d-xo.html
Great explanation! Thanks!
Nice to hear that! Thank you. :-)
thanks so much for this short yet precise and on point
Glad you enjoyed it! Please subscribe to the channel, and take a look if there are more videos that are helpful for you. I cover a lot of different accounting and finance terms!
@@TheFinanceStoryteller I already did since yesterday 😊. I’m preparing for a test and you’ve been a huge help. I understand multiple terms and concepts better now. Thank you!
This video is very useful to me. Thank you.
You're welcome! Happy to hear that.
Thanks very easy to understand. My question would be:
When purchasing a Lorry for $100.
1. Cr Cash $100 & Dr NCA $100
2. Dr depreciation yr 1 $50 & Cr Accumulated depreciation yr 1 $50.
Dr depreciation yr 2 $50 & Cr Accumulated depreciation yr 2 $50
3. Cr NCA $100 & Dr Disposal $100
4. Cr Disposal $100 & Dr accumulated depreciation $100
These accounts then have value of $0 except of depreciation having still Dr balance of $100. Do you leave it like that or there is a transaction we should do ?
Good question, and good thinking so far! Depreciation expense is an income statement account. At the end of every year, the income statement accounts (revenue as well as expenses) get summed into net income, and then net income is added to equity (or net loss subtracted from equity depending on the outcome of the calculation). Every new year, depreciation expense in the income statement will start with a zero balance. See my video on income statement and balance sheet relationship: th-cam.com/video/wZdaVEX41WQ/w-d-xo.html So to stay in your list: add a step 0 at the front to raise capital: Dr Cash $100 & Cr Equity $100, and step 2a roll $50 loss per year into equity, making the equity balance at end of year 1 $50 and end of year 2 $0. I hope your lorry also helped to transport goods and/or perform services, as that would generate a Dr Receivables & Cr Revenue. ;-) Another video that can help you is debits and credits explained: th-cam.com/video/n-lCd3TZA8M/w-d-xo.html
Thank you for your videos, my question is what happens if something doesn't live up to it's expected life? Like if you buy a truck for 1000 and estimate that it will last 4 years but it only last's for two, would you then go back to your previous reports and change the amount or would the last report just have a larger amount than the other ones?
Excellent question! The accounting concept of materiality comes in here. Materiality is the threshold above which missing or incorrect information in financial statements is considered to impact the fair and accurate representation of the financial situation. In very rare cases do companies have to retract an annual report, and resubmit it with updated numbers. In most cases, you will have to book the remaining depreciation (the one time "bad news") in one go in the current period. Doing that immediately will raise the question whether similar assets have to undergo the same treatment.
I recently made a video on straight line depreciation which discusses a case of tech companies extending the useful life of servers and network equipment (the opposite situation of your question), where they booked the benefit for the historical adjustment all in one go in the current period: th-cam.com/video/kbpStSSSzTM/w-d-xo.html
4:06
What is the significance of adjusting the depreciation schedule? What benefit is there to divide the depreciated amount over another 10 years?
Matching principle: allocating the expense over the years of usage.
@@TheFinanceStoryteller ah ok. But is it possible or legal to keep the original depreciation schedule of 10 years. Then once the useful life is up, the company still keeps the machine but stops depreciating it from the 11th year onwards?
That is a very good question, to which I would answer "it depends". ;-) Depreciation is important for tax accounting and reporting, and public reporting. Different rules might apply. For example, some countries allow companies for tax purposes to use accelerated depreciation (depreciating over fewer years than the actual economic life of an asset), as this creates a larger expense, and hence lower taxation, in earlier years of using the fixed asset. Check your country's tax accounting rules to see how that works. For public reporting, a large US company uses US GAAP, while a large non-US company would use IFRS. I would have to read up specifically what each of these accounting frameworks has to say about this specific situation. I have the feeling that you have a preference for continuing the original depreciation schedule and then using the asset "for free" (no depreciation expense) from the 11th year onwards. Most companies would probably choose to spread out the depreciation expense as I did it in my example in the video, as that has the better matching characteristics and leads to lower annual depreciation.
In the intangible asset segment, what is capitalized R & D?
Those are (part of the) Research and Development expenses that get put onto the balance sheet as an asset, and then amortized over time. More information in my CapEx versus OpEx video th-cam.com/video/na4jbAh_vkQ/w-d-xo.html and my Intangible Assets video th-cam.com/video/-TzaG-VD2GU/w-d-xo.html and my Amortization video th-cam.com/video/ci72a_SzFcQ/w-d-xo.html
Thank you so much very useful
You are welcome, Sarah! I have recently made two follow-up videos that could also be useful for you:
Straight line depreciation th-cam.com/video/kbpStSSSzTM/w-d-xo.html
Double declining balance depreciation th-cam.com/video/8vDt3ZF9hOA/w-d-xo.html
You are one of the best
Thank you for the kind words! Nice to hear that.
Now I'm struggling a little with this. You say that depreciation expenses are shown as an expense on the company's income statement.
I'm looking at the income statement of Walmart for 2012, and I don't see a "depreciation expense" anywhere on the Income Statement.
However, I see a depreciation write down on the balance sheet instead.
No only that, but I still fail to understand how "depreciation and amortization" is added to cash from operating activity, that in effect increases "free cash flow" overall?
I wish I could get a little more clarity on this matter, where it is explained using real company financial statements.
Hello Richard! Some companies split out depreciation and amortization as a separate line item in the income statement (for example Verizon - take a look at their annual report), others don't (Walmart, they probably lumped it into the category of Operating, selling, general and administrative expenses).
On the balance sheet, accumulated depreciation is expressed as a contra account, and rolls up into the "Property and equipment, net" line.
For the link between depreciation and cash flow, remember that depreciation is not paid in cash to anybody, it is what is called a "non-cash expense". The cash outflow (Capital Expenditure, in CFIA) happened when the fixed asset was purchased. Recording depreciation expense is merely an accounting entry to allocate the purchase price of the fixed asset over the years of use. When you look at cash from operating activities using the indirect method, you start with net income and then make adjustments from there to get to CFOA. Depreciation expense was deducted in the income statement in order to calculate net income. If you now change perspective to the cash flow viewpoint of CFOA, you will have to add back the non-cash expenses like depreciation and amortization (and others). Simply put, you add back what was deducted earlier to even out. Does that help? By the way, I have individual videos on most of the terminology above, just type finance storyteller followed by the term in the search bar and they should pop up.
@@TheFinanceStoryteller Thanks. That helps a bit. I appreciate the time given to your response. And, I appreciate the knowledge gained from your videos.
@@richardsalley9848 Happy to help! Take it step by step, these concepts need a bit of time to digest!
Ur the best bro, besttt
TYSM!!!!! Have you seen my recent sequel on straight line depreciation: th-cam.com/video/kbpStSSSzTM/w-d-xo.html
how do we get the accumulated depreciaton (20) and depreciation exp (20)
Hello Batweesya! In the example, I applied straight-line depreciation, and assumed a useful economic life of 5 years for an asset of $100K. For an example of asset classes that each have a different useful economic life, see my example on reading a balance sheet th-cam.com/video/eIjCaeNm-Vk/w-d-xo.html at 04:22. For an explanation of the concept of accumulated depreciation, see either th-cam.com/video/iOdEVUS2_fc/w-d-xo.html or th-cam.com/video/ixkdvOT7ZDI/w-d-xo.html
Were there vid explaining more abt method 2 (reducing balance)
I keep calculating wrong and write the accounts wrongly TT Thx!
Happy to help, Zara!
As due to depreciation the assets side of the balance side are reduced by the amount of depreciated value, So which particular item is reduced on the liability side so that the balance sheet stays in balance? For eg. Let's say a company has a total assets of $1000 & it depreciated that asset by $100 dollar, So at the end the company will have $900 worth of assets , but which particular item on the liability side will be reduced by $100 to maintain the balance of balance sheet.
Hi Krishan! The journal entry to record depreciation is debit depreciation expense (income statement) credit accumulated depreciation (balance sheet). Depreciation expense, like any other income or expense item, gets rolled into equity when preparing closing entries: th-cam.com/video/CXiKLtb7tqI/w-d-xo.html
Does this mean that I can take profita from my construction business buy a new truck and write 100% off my first year, or using the same analogy use the profits to buy a rental duplex and write off 100% ? Thank you for the information you are very intelligent
Thanks for your comment and question! Writing off a new truck or a rental duplex 100% in the first year, would violate what is called the "matching" principle: spreading the cost of what you bought over the years in which you use it. Accounting as well as tax rules rely heavily on that matching principle. In some countries, governments try to encourage you to invest in fixed assets by allowing you to depreciate the asset quicker, this is called accelerated depreciation. The quicker you can depreciate, the quicker you can record the expense in your income statement, the lower the tax you pay (at least in the first few years, it's "moving" the tax, not eliminating it). Bit of a long answer, hope it makes some sense!
Love from Bangladesh 🇧🇩❤
Sir
Hello Nafis! Greetings back from the Netherlands.
@@TheFinanceStoryteller 😇💖🙂😄
Youre saving my grades 😅
Happy to help! Follow-up videos on straight line depreciation and double declining balance depreciation in this playlist: th-cam.com/video/kbpStSSSzTM/w-d-xo.html&pp=gAQBiAQB
What if we don't include depreciation in accounting process . What's the effects ?
Then you are overvaluing the assets on the balance sheet, and understating the expenses in the income statement, and violating the matching principle: th-cam.com/video/50dztqkmiFg/w-d-xo.html
*Love the graphics.* _Thanks for the useful explanation._
thank you :)
You're welcome! :-)
Thank you sir.
Most welcome!
Thanks sir 🌹
Most welcome, Moaz!
Sir I am so tired to find depreciation's notes there is no proper notes anywhere surrounding me(shops, libraries etc) so please would you like to help me I will extremely thanks to you
Hello Haroon! I only make videos, I don't write books, but I can recommend the books "Finance for non-financial managers" by Gene Siciliano, and "How to understand business finance" by Robert Cinnamon and Brian Helweg-Larsen. These books have short sections covering depreciation.
Does accumulated depriciation becomes the money that is used
to buy the new fixed-asset?
No, not at all. You use cash upfront to buy an asset, then by depreciating it you spread that amount of money over the years of usage in expenses. The sum of what you have depreciated so far is accumulated depreciation. If you have fully written off an asset, and have to purchase a new one, then you start the same process from the beginning. Hopefully, you have made good use of the first asset you bought, and it helped you to generate revenue, profit and cash flow. If so, then you can use that cash flow to pay for the new asset.
@@TheFinanceStoryteller you sir are amazing! Thank you very much, I understand now!
@@nightking9435 Happy to help!
Still don't get it. Let say a company buy a machine using cash for $100,000 therefore we record that the cash decrease 100k and asset/tools increase 100k.
Then why we decrease the operating profit by this depreciation? Don't we already have decrease the cash in the beginning?
The journal entry you correctly propose affects the balance sheet. Debit fixed assets $100K credit cash $100K. Allocating that amount of $100K to the years in which the machine is used (let's say 10 years times $10K each), using the matching principle, gets the income statement involved, as you record annually debit depreciation expense $10K credit accumulated depreciation $10K. Depreciation expense affects operating profit, cash does not.
I know that current book value of an asset = purchasing cost - Accumulated depreciation. And if I sell the asset above it's purchasing cost then it will recognized as profit. But if I sell the asset above its current book value will that also be termed as profit?
For eg. Let's say purchasing cost = 10000
Accumulated depreciation = 4000
Current book value = 10000-4000=6000.
So will I earn profit if I sell the asset above 6000. If yes , then what is the difference between profit above book value (6000) and profit above purchase cost (10000)?
Hi Krishan! Let's say you sell the asset for 11000. Profit above book value is 5000. Profit above purchase cost is 1000. You would recognize the 5000 profit above book value in the financial statements of the current period. The profit above purchase cost is a "nice to know": you sold it for more than you originally bought it for, plus got to use it for a while (the period in which you depreciated the asset) and with the benefit of hindsight the use of the asset turned out to be "for free".
@@TheFinanceStoryteller Will both the profits go to Capital Reserves?
4000 of depreciation expense has hit net income in previous years, and therefore retained earnings in equity, over the past years. The gain of 5000 in the current year affects net income in the current year, this will also flow through into retained earnings in equity.
Thanks
Welcome!
Let me try to explain what I understand about depreciation.
It's the value of the item that gets lesser and lesser every year?
Idk why but I'm having a hard time understanding the meaning and the process. Erghh
Hello Tikitaka! That is correct. Depreciation represents the decrease in value per year. "Depreciation is the accounting process of allocating the cost of tangible assets to current expense in a systematic and rational manner in those periods expected to benefit from the use of the asset." The part about "in a systematic and rational manner" is very important in that!
@@TheFinanceStoryteller thank you!! I'm struggling so badly with accounting as it's my first year taking it in uni. And the lectures is hard for me to understand and idek why. So now idek what idk. Do u have any advice?
Sure! When I start to learn about a new topic, I try to make a list of things that I already understand, and then go from there. My "Accounting 101" playlist might help you, it has videos on the accounting equation, debits and credits, trial balances, etc. th-cam.com/video/b93KBmcXanI/w-d-xo.html Watch them as many times as you like! ;-)
What does Depreciation has to do with a company who doesn't buy trucks and cars or equipment? Can you answer this?
Very little..... depreciation is related to fixed assets. If you don't have those on the balance sheet, then no depreciation in the income statement.
@@TheFinanceStoryteller thank you for the clarification, it is extremely helpful. Can you help me understand a 5 year financial plan statements and terms?
I paid a professional financial advisor to compose a business plan with a 5 year financial plan. And was given a financial statement to approve and I have no idea what all of these terms are and how they relate to the startup company...
Hello Max! That doesn't sound right to me.... The entrepreneur and the financial advisor should always be aligned on what the vision, mission, and strategy of the company is, and its related financial "footprint". Take a look at my video about the financial aspects of making a business plan: th-cam.com/video/FC0ZODWFzpo/w-d-xo.html
@@TheFinanceStoryteller Thank You
Why do we have different kinds of depreciation method?
Because opinions differ on how to spread the "usage" of a fixed asset over its expected useful life. Does its value get "consumed" in exactly the same amounts per year (straight-line depreciation) or does it have most value "consumed" in early years rather than later years?
@@TheFinanceStoryteller thank you! That's very helpful :)
It's why it is very useful when you review the financial statements in the annual report of a company to not just analyze the numbers, but also read the section with "Significant Accounting Policies", more specifically the paragraph on "Property, plant and equipment", which discloses which depreciation method is used! If two identical companies use different depreciation methods, then they end up with different numbers of net income in the same year (although it does even out over time, obviously).
Intangible is materials
Hello Nestor, please take a look at the related video on amortization th-cam.com/video/ci72a_SzFcQ/w-d-xo.html and intangible assets th-cam.com/video/-TzaG-VD2GU/w-d-xo.html
12k views and no comments?
Haha! Well, thank you for being the first one then. :-)
Why would you depreciate the asset over a fixed amount of years instead of just deducting all of it for tax purposes at once?
That certainly works for the tax books (if allowed by the tax authorities), but not for the US GAAP (or IFRS) set of books that companies put together for stock market filings. The two different treatments of depreciation (tax vs book) creates a deferred tax liability: th-cam.com/video/7QKvzNV1Qw8/w-d-xo.html
The Finance Storyteller I am a sole proprietor who is just learning about accounting this week so apologies. I think I need to keep learning more lol
Welcome to the world of accounting, my friend!!! Here's a playlist with some of the basics that I think will benefit you: th-cam.com/video/OYql7Y9NnBg/w-d-xo.html
@@TheFinanceStoryteller So is it only public companies that have to apply the laws of GAAP/IFRS who normaly use the depreciation method for assets/liabilities. If you are a sole proprietor or have a small ltd/llc company you would just deduct your assets 100% in the same year?
One of the main ideas in all accounting frameworks (whether you are a company listed on the stock market, or a small one) is the matching principle. If you use a machine for 5 years, then it is appropriate to depreciate the machine over 5 years. You will need to check local statutory and tax regulations for small companies to see if accelerated depreciation is allowed.
voice is not clear 😔😔
Please turn on the subtitles. Maybe a combination of audio and subtitles works for you.
Will you be my accountant?
Hello Nathan! Thanks for the offer, but I prefer making TH-cam videos. ;-)
How many chemical engineers here😂
Welcome, Sadiq!
Hello Sadiq.... I'm from University of Port-Harcpurt. 😀
Audio is bad sounds like a public bathroom
Sorry for that! This was one of the very early videos on the channel, and I was still experimenting with the setup. I have recently made a follow-up video on straight line depreciation th-cam.com/video/kbpStSSSzTM/w-d-xo.html and another one on double declining balance depreciation th-cam.com/video/8vDt3ZF9hOA/w-d-xo.html The audio and video quality on those should be better.