So let's start our discussion of depreciation methods with the most common one, the straight line method. Before we dive into the different methods, the first thing I want to do is talk about depreciation on a high level, relating to all the different methods. Remember that what depreciation does is break up the cost of some high value items, a fixed asset that we're going to use for multiple years. We're going to break up that cost that we spent upfront over the useful life of the asset. We'll be using it for many years. And why do we use depreciation? Well, GAAP requires it because it's an example of the matching principle. Remember that with the matching principle, we earn revenues, and we want to match the expenses that helped us earn those revenues.
Let's see here, why depreciation expense is an example of the matching principle. We've got two boxes here. The bad way is represented by the salmon color, and the good depreciation expense way is in green. Let's see why we don't want to do it from the cash basis perspective. Consider an airline company, like American Airlines, which purchases an airplane for $20,000,000. In the bad way, they're not going to capitalize the asset and depreciate it. Instead, they write it off as an airplane expense immediately, $20,000,000 in the first year upon purchase, which they paid for with cash. However, this airplane will generate revenue for 20 years, generating $5,000,000 per year. Notice, in the first year, we match some expense against some revenue, but from year two onwards, there is only revenue, no matching expense. The expense helps us earn that revenue in terms of the airplane used, but it's already been expensed. This doesn't align our revenues with our expenses very well.
Now let's look at the good way when we are using depreciation expense. Fixed assets, as learned in our cost lesson, are capitalized, put on our balance sheet as an asset. Purchasing the same airplane for $20,000,000 will now be entered into an equipment or fixed asset account, signifying asset ownership, with cash still going out. Yet, no expense is recognized now. Over the years 1 to 20, revenue is still generated but paired each year with a depreciation expense. As discussed, a simple example of the straight line method where we take a $20,000,000 airplane with a 20-year useful life results in $1,000,000 of depreciation expense per year. Each year, we debit $1,000,000 for depreciation expense and credit accumulated depreciation, which is a contra asset account that grows with credits and subtracts from the value of the asset. This method correctly matches the expense of using the airplane with the revenue earned each year, contrasting sharply with the bad example.
Depreciation expense is a non-cash expense, which is essential once we address the statement of cash flows. The expense doesn't require additional cash outlay since it was all paid upfront; the cost is merely allocated over the asset's useful life. Also, depreciating an asset does not indicate its market value, only book value, which is calculated based on historical cost minus accumulated depreciation.
Now, addressing depreciation calculations. It involves three crucial factors: the initial cost of the asset, which is usually given straightforwardly, the useful life, and the residual value, which have to be estimated. Residual value can also be known as salvage value, scrap value, or end-of-life value. These factors require estimation and may vary from their actual outcomes.
Now that we are familiar with the high-level concepts about depreciation, let's pause and then we’ll go into our first depreciation method, the straight line method, and do an example there. Let's pause now.
