Accumulated depreciation is an accounting term used to assess the financial health of your business. This post will help you understand what accumulated depreciation means and how you can calculate it to simplify your bookkeeping.
Accumulated depreciation can be defined as the total amount of depreciation for a fixed asset that is charged to expense since that asset was acquired and made available for use. The accumulated depreciation account is a contra asset account. This means it is a negative asset account that offsets the balance in the asset account to which it is usually linked.
Typically, there's an original basis for every asset you have in use, equal to the original purchase price. Then, there's accumulated depreciation or the value lost in the asset, which is considered an expense on your books.
So, suppose you're recording depreciation on a tangible asset. In that case, you will debit the depreciation expense and credit the accumulated depreciation for the same amount to reflect the asset's net book value on the balance sheet.
The journal entries for the accumulated depreciation will help you determine how much of an asset has been written off and its remaining useful life.
Eventually, when the asset is retired or sold, the amount recorded in the accumulated depreciation and the asset's original cost will be reversed. This will eliminate all asset records from your balance sheet, which is vital as it prevents the building up of massive gross fixed asset costs and accumulated depreciation on your balance sheet.
Here's an example to understand this better. Waggy Tails, a pet grooming company, purchases some equipment with a useful life of 10 years for $110,000. Once the useful life of the equipment is over, Waggy Tails can salvage $10,000.
Now, as Waggy Tails will use the equipment for the next ten years, it will expense the cost of the equipment for the entire period. Using the straight-line depreciation method, Waggy Tails finds that the asset will depreciate by $10,000 a year for the next ten years until its book value is $10,000.
Simultaneously, each year, the contra asset account or accumulated depreciation will increase by $10,000. So, at the end of 3 years, the annual depreciation expense would still be $10,000. Still, the accumulated depreciation would have grown to $30,000. In this way, accumulated depreciation will be credited each year while the asset's value is simultaneously written off until it is disposed of or sold.
Now, consider that Waggy Tails decides to use the equipment at the end of 10 years. Even then, the accumulated depreciation cannot exceed the asset's original cost, despite remaining in use after its estimated useful life.
In all probability, you will find accumulated depreciation listed as a credit balance just below the fixed assets on the balance sheet. If you don't see it next to the fixed assets, you may notice a column listing the net costs for property, plant, and equipment. In this case, you can head to the financial statement disclosures to find details about the book value of the company's assets.
Here's an illustration of the asset section of a balance sheet for Waggy Tails:
Some companies may list depreciation for plant, machinery, and equipment separately under the value of each item instead of a cumulative figure used in the above example.
Accumulated depreciation is also known as a contra asset account. This implies accumulated depreciation is a negative asset account used to offset the balance of the asset account with which it is associated.
The purpose of stating accumulated depreciation on the principle balance sheet is to help the readers understand the original cost of an asset and how much of it has been written off. It may also help them in estimating the asset's remaining useful life.
However, accumulated depreciation is not a current asset. The reason is that current assets are not depreciated because they are not expected to last for more than a year.
There's no standard formula for calculating accumulated depreciation. Still, there are two methods primarily used for the calculation – straight line and double-declining balance.
The straight-line method is the simplest method for calculating accumulated depreciation. In this method, you depreciate an asset at an equal amount over each year across its useful life.
To calculate accumulated depreciation with the straight-line method, follow the steps outlined below:
- Subtract the asset's salvage value (salvage value is the book value of an asset after all depreciation has been fully expensed) from its purchase price to get the amount that can be depreciated.
- Divide the amount in the above step by the number of years in the asset's useful life to get annual depreciation.
In Waggy Tails' example:
Annual Depreciation = [$110,000 (Purchase Price) – $10,000 (Salvage Value)] / 10 (Years in Useful Life)
The result is $10,000, which is the amount that will be depreciated from the asset every year until there's no useful life remaining.
In this method, the asset depreciates swiftly in the earlier years, using a depreciation rate of 2. The following formula is used for calculation:
(Purchase Price – Salvage Value) X ( 1 / Years in Useful Life) X 2
For Waggy Tails, depreciation expense for the first year would thus be:
($110,000 - $10,000) X (1/10) X 2 = $20,000
In the second year, you will deduct the total depreciation expense from the purchase price ($110,000 – $20,000) and follow the same formula.
($90,000 – $10,000) X (1 / 10) X 2 = $16,000
You can continue following the same formula for the remaining useful life to determine how much an asset will depreciate over time.
The IRS requires businesses to depreciate specific assets using the Modified Accelerated Cost Recovery System (MACRS). For this method, the IRS assigns a useful life to various asset types. For instance, automobiles depreciate over five years, and commercial real estate is depreciated over 39 years.
To calculate depreciation using MACRS, you first need to determine the asset's classification. Once this is done, use the tables found in IRS Publication 946 to calculate the depreciation for that year.
Irrespective of the method used for calculating depreciation, the recording for accumulated depreciation includes both a credit and a debit. That's because you're required to make a debit to depreciation expense and a credit to accumulated depreciation.
However, when you eventually sell or retire an asset, you debit the accumulated depreciation account to remove the entry for that asset.
This is how the entry will look once Waggy Tails sells the equipment after its useful life.
Accumulated depreciation is a simple concept, but if the numbers are getting the better of you, you can reach out the industry-leading bookkeeping services like Fincent to help take care of all your finances while you focus on scaling your business.