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Depreciating the truck

Depreciation the truck spreads out the expense. Created by Sal Khan.

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  • leaf green style avatar for user Mikah Crapse
    Wouldn't it be more truthful to list 60k as an expense the first year. Then every year after that list a 20k expense that essentially goes to the next purchase of a truck. So that you never are listing expenses after being expended? Perhaps it would solve the problem that the expenses really don't show what the business is doing?

    On another note, Why not list that your truck lasts 5 years, and depreciate it that way? So that you only spend 12k per year until a surprise expense of 24k per year
    (15 votes)
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    • blobby green style avatar for user CA. Y. K. Bhargava
      It will be untruthful to charge 60k as expense in the very first year. That will falsify the figure of net profit/loss for that year. The truck shall has certain resale value after the 1st year, hence only the fall in value of the truck during the 1st year should be charged to the profit and loss statement for the 1st year. Please also note that the "Matching Concept" requires that only that expense should be charged to the P&L which matches the revenue for that period. Thus, to charge 60k against the revenue of 1st year will be unjustified as 60k is an expense for 3 years.
      (21 votes)
  • blobby green style avatar for user Andrew McSwain
    Someone please make a logically coherent and well-justified argument that not recording the expense when and how it was paid somehow reflects reality more accurately. I can see why depreciation of a truck would make your balance sheet prettier to an investor or loan-officer, but for a manager it seems that such contortions would make it more difficult to know the true nature of the capital flows of your business.
    (5 votes)
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    • male robot hal style avatar for user Andrew M
      It depends on what you are using the books for. If you are trying to understand your profitability, it makes no sense to charge the truck all as an expense in one quarter.(that means in all the other quarters, you have no truck expense?) If you are trying to understand your cash flow, it does. Managers have to use financial statements intelligently, and they need to look at them in more than one way.
      (6 votes)
  • leaf green style avatar for user ram_abhiram
    can agricultural land be depreciated;as the fertility of soil reduces when cultivated, from year to year?
    (4 votes)
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    • leaf yellow style avatar for user Erik Carlson
      No. Land is not depreciated since it has an indefinite useful life (land lasts for a very long time!). Land is only recorded as an expense on the income statement in the period if it is held for resale and sold to customers. In such cases, land is not a capital asset but is treated as inventory.
      (6 votes)
  • male robot hal style avatar for user Enn
    Is the Written Down Value the value of a commodity after subtracting depreciation from the original cost ?
    Also is the written down value the same as the book value ?
    (3 votes)
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    • leaf green style avatar for user Ryan
      When you write something down you are getting a new book value for the asset. How you arrive at the new book value can be a complicated procedure depending on the type of asset and how it's reported. A company writes something down because it's current value varies greatly from what is reported on the balance sheet.

      If the asset had been owned long enough to be depreciated, depreciation would have already been subtracted from the book value of the asset before the write down ever happened. Depreciation is usually subtracted every reporting period.
      (3 votes)
  • mr pants teal style avatar for user ericp
    At sal ends the video by saying spreading out the expense of the truck results in numbers that are more consistent with what the business is actually doing. Is that a generally accepted truth? It seems LESS consistent with what the business is Actually doing.

    I understand that averaging the operating profit out over a few years gives a better idea of how profitable a business is than just looking at one year, but why is it necessary to Capitalize and Depreciate assets to do that?
    (1 vote)
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    • leaf yellow style avatar for user Erik Carlson
      Not really — for accounting purposes, the purpose of depreciating any asset is to spread out the cost of the asst over its useful life of economic benefit. For example, if the company thinks it will be using the asset for eight years, then it should depreciate it over eight years. Generally accepted accounting principles (GAAP) allows various methods of depreciating assets (straight line method, declining balance method, etc.), but it must choose a method and use it consistently from year to year. However, for tax purposes, tax laws dictate what rates and methods must be used for depreciating assets when the tax return is prepared each year — so net income must be adjusted accordingly on the tax return for differences between what revenues and expenses are allowed for accounting purposes vs. tax purposes. The rates and methods set by tax laws may differ from the rates and methods chosen by the company for accounting purposes.
      (4 votes)
  • orange juice squid orange style avatar for user Mikey
    How would accounting be affected if the truck were to last past it's expected lifetime? Or maybe break down before the truck's expected end-of-life? Also: which would be more beneficial for tax purposes: categorizing the truck as an asset or categorizing it as an expense?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      If it breaks down early, you have to take an additional write off.
      If it lasts longer than expected, the rules don't allow you to make any adjustment, so your profit will look higher than it should.
      You almost always want to take tax deductions as soon as you can, so you would want to expense the truck, but the tax rules usually will not allow that.
      (3 votes)
  • blobby green style avatar for user Darryl M
    How is "useful life" determined?
    (1 vote)
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  • piceratops ultimate style avatar for user tian1di2 jax
    if there's a publicly traded company with consistent earnings then wouldn't the stock price go down because the corporation isn't growing even though it's a rock solid business?
    (1 vote)
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  • duskpin ultimate style avatar for user Abby
    What would happen if the truck's cost raises or lowers?
    (1 vote)
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  • male robot hal style avatar for user John Byrne
    Is it important to record the depreciation accurately at every step? In other words, if I know the truck is worthless after n years, do I spread it out evenly until I get to zero, as in this video, or do I have to do something to calculate the actual value every year (in which case it might not be linear)?
    (1 vote)
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    • blobby green style avatar for user Haider Ali
      It is vital that we understand that depreciation has nothing to do with the value of an asset after n years. It is just that you need to record the benefit obtained as an expense (depreciation charge) over the useful life of the asset.

      Because an expense is nothing more than a benefit obtained from an asset.

      There are multiple ways to charge depreciation based on the pattern of benefit obtained e.g. Reducing Balance Method may be used if more benefit is derived from use of an asset in initial years of the useful life than the later years
      (1 vote)

Video transcript

Voiceover: In the last video, we had this situation where we have to buy a truck every 3 years, because that's how long they last, and we were, at first, just expensing the truck. It's $60,000 every 3 years, but it did something very strange to our operating profit. It made it look like, the years that we bought the truck, that our business didn't do well, and the other years, it did really well, even though this was a really consistent business. What we hinted at in the last video is, maybe we can do something called "capitalizing" the expense. We could capitalize the truck. What we do is, instead of just saying that the truck is an expense, we can say that we're buying an asset, that has some useful life beyond the time that we're just expensing it. What we do is, let's just put a balance sheet right here, at the beginning of year 1. At the beginning of year 1, this is our balance sheet. Balance sheet, right over here. By capitalizing a truck, we're essentially saying we're going to spend $60,000. Let's say we start with $60,000 in cash. We use that $60,000 in cash to buy a truck, so on our balance sheet we now have only 1 asset, called "a truck." Let me do it this way. In the asset category, we have a truck, and we are saying that right when it's brand new, it is worth $60,000, and we have no liabilities, so I'll just put a 0 there, and so our equity, our shareholders' equity, 60,000 - 0, which is 60,000. Our company is worth $60,000 on our books. The way that we account for this truck, that lasts 3 years, is we say, "Look, this has a useful life of 3 years." Essentially, "Let's just spread that $60,000 out, "over the 3 years," or another way to say it, let's say that this truck is costing us $20,000 a year. $20,000 a year. Or, another way we can say that, is that we can depreciate the value of the truck, and the depreciation is an expense. So, "depreciation of truck." Instead of just calling it truck, I'll call it the truck depreciation. You could just really view this as a way of spreading out the cost of the truck. In the first year, we're going to depreciate our truck by 20,000. We're going to say that it's 1 third ... 1 third of its value has been served, or it's now $20,000 worth less at the end of the year, than it was at the beginning. In the second year, 20,000. In the third year, 20,000. We just really spread out the 60,000 over the life of the truck. What that does is, it makes our operating profit consistent, which it should be, because we have a very consistent business. 100 - 50 - 20. We make 30 in year 1, 30 in year 2, 30 in year 3, and then we just keep going. These all become 20s, and so, because we have such a consistent business, we make $30,000 the whole way through. What does depreciation do to our balance sheet? At the beginning of year 1, we had a truck that was worth $60,000. If you forward to the end of year 1, or the beginning of year 2, what's going to happen is, because we're depreciating the value of the truck, on our balance sheet we took $20,000 depreciation expense, on our balance sheet the value of the truck over the course of the year will go from 60,000 to 40,000. To 40,000. Then at the end of year 2, if we go another year forward, the value that we keep the trucks on the books for will go down to 20,000. Then at the end of year 3, it's going to go down to 0, and then we go buy another truck, so we'll go back to 60,000; we'll keep going. The cool thing about this is it makes the expense very consistent, and actually more consistent with what our business is actually doing.