AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 1 Property-Plant-Equipment: Module 7 Slide 1 Hi everyone. Now that we’ve gone through the first two depreciation methods, straight-line and double declining balance, let’s spend some time in this module and talk about the third method, the units of production method.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 2 Slide 2 Now the units of production method is very different from both straight-line and double declining balance in that UOP bases the depreciation on the actual usage of the asset. It does not base depreciation on time. Both straight-line and double declining balance base the depreciation on some estimate of the number of years that the asset will be used, time. Units of production completely ignores time in its calculation, rather it bases the depreciation on the actual usage of the asset.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 3 Slide 3 Now let’s talk a little bit about units of production depreciation. And we already know that UOP bases depreciation on the actual usage of the asset, not on time. Now this is a big advantage. In fact this is the main advantage to the units of production method. Basing depreciation on the actual usage of the asset best follows your generally accepted accounting principles, specifically the matching concept. Think about what depreciation is. It represents the using up of our buildings and equipment. So basing the depreciation calculation on the actual usage of the asset only makes sense. It better follows the matching concept much more so than both straight-line or double declining balance depreciation. So big advantage to UOP, it follows generally accepted accounting principles the best. But what is an advantage is also a disadvantage. And a big problem with the units of production method is that the estimates that are required to do the calculation are very difficult to develop for some assets. Now think about this. We are basing depreciation on the usage of the asset.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 4 For an automobile, coming up with how we measure usage is very easy. We’ll look at miles that were driven. But for a building, how would you measure usage? How would you come up with the usage of a building while attempting to ignore time? I don’t think you can. There’s no way to do it. So for a lot of assets, using the units of production method won’t work. There’s now way to develop reasonable estimates that are required by the method. However for some assets, automobiles being a good example, this method works very well.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 5 Slide 4 To calculate the units of production depreciation, what you do is you’ll take the cost of the asset, minus its residual value and you will divide, not by the life, but you will divide by the total expected usage of the asset. That gives us a depreciable cost per unit. For example, if we are basing depreciation on miles, we have an automobile, and we’ll divide by the total expected miles to be driven, that will give us a depreciable cost per mile. The cost that is depreciated for every mile the automobile is driven. We then take that depreciable cost per unit and we’ll multiply by the actual usage in the current year to get the depreciation expense for that particular year. Now let’s see if we can apply the units of production method. Take a look at example number three, back to Nick’s Nature Trails and just as a refresher we know that on January 1st of 2001, this company purchased a truck, it costAMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 6 38,000, had a $4000 residual value, and a four-year life. It then said that the truck is expected to be driven for a total of 85,000 miles. It then tells us the amount of miles the truck was driven in the first two years, 2001 and 2002. Note in requirement C it wants us to do the calculation for units of production using only the first two years. So it only wants the calculations for the first two years.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 7 Slide 5 So for that very first year, for 2001, we will take the cost of the asset, 38,000 minus the $4000 residual value, and we will divide by the total expected usage given in our problem as 85,000 miles. This tells us we are depreciating $0.40 for every mile driven. We’ll then take the $0.40 and multiply it by 22,000, it told us in the problem in that first year in 2001, 22,000 miles were driven to get the depreciation expense for 2001, $8,800.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 8 Slide 6 We can follow the same process for 2002. Cost 38,000 minus residual 4,000 divide by the 85,000 miles. Again we have a depreciable cost of $0.40 per mile. We’ll then multiply that $0.40 by the miles driven in 2002, given as 26,500 and we’re able to calculate the depreciation expense in 2002, $10,600.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 9 Slide 7 So we now know the amount depreciated in each year. We can calculate the book value of the truck at the end of each of these years by taking the cost minus the accumulated depreciation. At the end of the first year, 38,000 minus 8,800, giving us a book value of $29,200. At the end of the second year the cost was 38,000 and the accumulated depreciation would now be the two years combined, totaling 19,400, giving us an end of year book value $18,600. Now please note the truck will be fully depreciated once it has been driven 85,000 miles. Once it has been driven 85,000 miles its book value will equal the $4,000 residual value. In this particular problem, the residual value was 4,000. That’s how to do the units of production depreciation calculations.AMIS 212 – Introduction to Accounting II AMIS 212 – Marc Smith 10 Slide 8 And we remember, units of production is based on actual usage. It is not based on time. And because it is based on actual usage, there really is no pattern to the amount of depreciation recorded in each year, as it is simply dependent on how much of the asset has been used in that particular year. Unlike straight-line, which was equal depreciation over