Units of Activity Depreciation Method

>>We’re going to look at the units
of activity depreciation method for fixed assets or property
plant and equipment. The cost is $200,000 for the equipment. The salvage or residual value is $20,000. And the useful life is five
years and 20,000 machine hours. Some pieces of equipment have an internal
clock, so we use machine hours to track usage. If this were a vehicle, we
could use miles driven. Certain machinery that produces inventory,
we could even use units produced. But in this example, we’re
going to use machine hours. Now, I have to provide you both the total
estimated hours over the life of the asset, and I have to provide you with the
number of hours used each year. Okay? So notice the formula for units of activity depreciation method is cost minus
salvage value, which is the same numerator as straight line depreciation, but instead of
using years we use the total estimated activity. I’m going to put the numbers in here. Cost is 200,000. Minus the salvage of $20,000. Divided by 20,000 machine hours. And that’s going to give us $9 of
depreciation expense per machine hour. This is step one, calculating the
depreciation expense per unit of activity — whether it’s miles, units produced, hours, or
what other measure a company chooses to use. Now step two is to determine the amount of
depreciation expense recorded each year. If for each hour that we use the machines
we record $9 of depreciation expense, then in year one I’m going to
simply multiply 3,500 hours — and again, I have to provide
you that information — times 9. That gives me $31,000 of depreciation expense. Now, I put up a schedule here that
I think you’ll find very useful when doing deprecation for
any method that we use. Notice we have four columns; beginning book
value, depreciation expense for the year, accumulated depreciation, and ending book value. We’ll assume that the year
ends on December 31st. Beginning book value would be January 1st. Ending book value would be December 31st. Now the beginning book value in year one — I’m going to put a little line separating
this — is $200,000 which is the cost. And the reason we use cost as beginning
book value year one is we have not yet recorded any depreciation. So cost minus accumulated
depreciation of zero equals cost. So in year one, beginning book value is cost. When I multiply the number of hours
for year one that we use the machine, times $9 of depreciation per hour. That gives me depreciation expense of 31,500. So in year one my adjusting journal entry to record depreciation is debit
depreciation expense 31,500. Credit accumulated depreciation 31,500. You want to know that adjusting entry. Okay? And I’m also going to keep the T
account for accumulated depreciation up here so you can see how it accumulates. Now remember book value, which
is the amount we have to show on the balance sheet is cost
minus accumulated depreciation. So at the end of year one, cost of
200 minus accumulative of 31,000, my ending book value is $168,500. Think about it. The end of year one, the clock strikes midnight and all of the sudden it’s
the beginning of year two. So my beginning book value for year
two was last year’s ending book value. So 168,500. Now depreciation expense in year
two, I’m going to do the same thing. I’m going to multiply it times $9. And 4700 hours of machine
use times 9 is $42,300. That’s the depreciation expense that
will go on year two’s income statement. So for accumulated depreciation — it accumulates, right, and so now we
have 73,800 of accumulated depreciation. And remember, book value
at the end of the year — cost of 200 minus accumulative
of 73,800 gives us 126,200. Okay. And my lines aren’t
perfectly straight here, but hopefully you can go across and see them. Beginning book value for year three, which is
ending — year two’s ending book value, 126,200. I multiply the 4800 hours of usage in year
three, times 9, and that gives me $43,200 of depreciation expense in year three. I’m going to accumulate that. And what do we have here? 117 of accumulated at the end of year three. And my book value at the
end of year three is 83,000. Again, cost of 200 minus
accumulated of 117 equals 83. Beginning of year four, beginning
book value 83,000. 4300 times $9 of depreciation per hour gives us
$38,700 of depreciation expense for year four. Let’s add that to accumulated depreciation. And we have 155,700 of accumulated. And that gives us ending book
value of 44,300, end of year four. And that, of course, becomes
beginning book value for year five. Now year five, we have to be careful. Actually, the last couple of years you simply
have to be aware that you are not allowed to depreciate an asset below the salvage value. You simply have to remember that. So if we multiply 4100 times
9 that gives us $36,900. Let’s add that to accumulated. And accumulative is 192,600. And that means my ending
book value would be 7,400, which is well below the salvage value of 20,000. So I’m not allowed to do that. I cannot depreciate below salvage value,
so I cannot record the full amount of the calculation that we came up with. Instead I have to know that ending
book value cannot be below salvage. In this case 20,000. That means accumulative depreciation
cannot exceed 180,000. So how do I figure out the
depreciation expense for the last year? I look at the difference between the
accumulative depreciation here at end of year four and what it needs to be in year
five, and the difference looks like what? $24,300. Okay. And we could do the same thing here. The difference between the
ending book value in year four — the ending book value has to
be at the end of year five so that we don’t depreciate below salvage, my depreciation expense in
year five would be 24,300. And that would mean my ending
accumulated is 180. Okay? Now, you can still own this asset for many
years after this, you simply are not allowed to record any more depreciation expense. So you have to be aware that in the last couple of years you’re going — you
may run out of depreciation. That’s not a problem. Okay? So this is called the units
of activity depreciation method.

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