An account representing the total depreciation a physical asset has incurred from its purchase date up to a specific period.
Accumulated Depreciation Details
Depreciation is an accounting method that gradually reduces the value of a physical/tangible asset over its useful life. A simple example is if you own a car. Typically, you would expect that it becomes cheaper the older it gets. Depreciation exhibits the cost of using a particular long-term asset to generate revenue. Accumulated depreciation is the total amount of an asset’s value reduction up to one specific time.
Accumulated depreciation is classified as a contra asset account in the general ledger. This means that accumulated depreciation acts as the opposite of its associated account, in this case, the capital asset account. The more the accumulated depreciation amount, the less the asset value.
The act of recording accumulated depreciation needs to follow the matching principle dictated by Generally Accepted Accounting Principles (GAAP). The matching principle requires companies to record expenses at the period in which they incurred them. When a bookkeeper records an asset’s depreciation in the ledger, they debit the depreciation expense and credit on accumulated depreciation. On the balance sheet, accumulated depreciation is located just below the line of its associated asset account.
Example of Accumulated Depreciation
A company owns a computer with a purchase price of $2,000. The company bought the computer brand-new six years ago. Additionally, the asset has an estimated useful life of 10 years and a salvage value -- the leftover value after all depreciation is completed -- of $400. To make things easy, we’ll use the simplest method of depreciation to calculate the cost of using the asset over its useful life: straight-line depreciation.
With straight-line depreciation, we depreciate the asset at a constant rate, represented by a straight line on a graph. However, we need to determine the total depreciation value by subtracting the salvage value from the asset’s initial value: $2,000 - $400 = $1,600. Using this information, we can allocate the same portion of depreciation per year over ten years: $1,600 / 10 = $160. The amount of the computer’s depreciation per year is $160.
To record depreciation, bookkeepers need to include the contra asset account to the computer asset, referred to as accumulated depreciation. The accumulated depreciation is increased by $160 per year on the balance sheet. Since the company purchased the computer six years ago, accumulated depreciation has grown to $960 ($160 X 6). Each year, the company credits accumulated depreciation and reduces the computer’s carrying value until the asset reaches the end of its useful life. On the off chance that the computer is still being used after ten years, accumulated depreciation shouldn’t surpass the asset’s initial value.
Significance of Accumulated Depreciation
One of the reasons companies accumulate depreciation is to provide accuracy for analysis purposes. It’s only natural that the longer a physical asset is used, the lower its value. The decrease of an asset’s value can also come from outside sources such as introducing new models and inflation. However, keep in mind that an asset’s carrying value (the current value of an asset that considers depreciation) may differ from its market value (the actual value of the asset’s if it’s sold on the market).
Accumulated depreciation is also helpful for tax purposes. Using one of the depreciation methods, businesses can arrange the calculation so that depreciation expenses can lower pretax income by a certain amount. Lower Earnings Before Tax (EBT) means less tax payment. On the contrary, companies can also minimize depreciation expenses to show larger net income to attract investors.
Apart from straight-line, there are other methods of depreciation. The most common methods are declining balance, double-declining balance, and sum-of-the-year’s-digit. All of these methods are known as accelerated depreciation. Accelerated depreciation is any depreciation method that sets higher depreciation expenses in the early years and lower depreciation in the later years. Which depreciation method a company chooses predominantly affects accumulated depreciation throughout the periods.
Accumulated Depreciation vs. Accumulated Amortization
Amortization is similar to depreciation. The main difference is that amortization calculates the cost of using intangible assets (e.g., copyrights and patents), whereas depreciation is for tangible assets. In that case, we can deduce that accumulated amortization is the cumulative amount of an intangible asset’s amortization expenses up to a certain date. To put it simply, accumulated depreciation deals with physical/tangible assets, while accumulated amortization deals with intangible assets.