What is accumulated depreciation?
Accumulated depreciation signifies the total reduction in the value of a company’s assets on its financial statements from acquisition to the current date. It’s used to calculate an asset’s net book value. It represents a credit balance, and its account is classified as “contra asset,” which means that its natural balance is a credit that reduces the overall asset value.
Companies can easily track asset depreciation and calculate accumulated depreciation using asset tracking software.
The generally accepted accounting principles (GAAP) state that expenses need to be matched over the same accounting period as revenue generation. Over each year of its useful life, a business expenses a portion of the capital asset’s value. Put simply, the cost incurred with using the asset is recorded every year.
The account balance increases quickly if a company uses the accelerated depreciation method. In this method, there are more charges to the cost of an asset during its early use. Using the accelerated depreciation method makes it difficult to judge the age of a fixed asset.
What are depreciation expenses?
Depreciation expenses are the specific portion of the cost involved with tangible assets. Depreciation expenses are recognized on a company's income statement as a non-cash expense, and they reduce a company’s net income and profits. Depreciation is the allocation of an asset’s cost over its useful life.
While accumulated depreciation normal balance is considered credits, depreciation expenses are considered debits.
Why are depreciation expenses considered non-cash? It’s because the recurring monthly depreciation entries do not involve cash transactions.
There are four methods to calculate depreciation:
- Straight-line
- Declining balance
- Sum-of-the-year's digits
- Units of production
Depreciation is generally calculated using the straight-line method.
Accumulated depreciation gets recorded as a contra asset account on a company’s balance sheet. This means that it has a credit balance, which reduces the gross value of a fixed asset. Accumulated depreciation is not recorded as an asset or a liability.
Depreciation expenses are recorded on the books as an expense. They represent how much an asset’s value is used over a year. These are neither an asset nor a liability.
How to calculate accumulated depreciation
Accumulated depreciation is the total depreciation of a capitalized asset up until a certain time. The accumulated depreciation expense gets recorded over each period and is added to the beginning of the accumulated depreciation balance.
Companies can use the straight-line method to calculate depreciation, shown in the formula below:
Depreciation = (cost of the asset - salvage value) ÷ useful life
Here, salvage value is the estimated book value of the asset after the depreciation is complete. It’s based on what a company expects to receive for that asset at the end of its useful life, the number of years an asset is expected to last.
Example of accumulated depreciation
A company has an asset that is worth $60,000. The company estimates the asset's salvage value to be $5000 and the asset’s useful life to be 10 years.
Subtracting the salvage value of the asset from its original cost, we get:
($60,000 - $5000) ÷ 10 = $5500
This is the total amount of depreciation expense per year. It means that for the next ten years, the company will depreciate $5500 until the book value of the asset is $5500.
Accumulated depreciation is the total value of depreciation expenses since the beginning of an asset’s usage period.
The accumulated depreciation formula is:
Accumulated depreciation = depreciation expense x current usage
If the current usage of the asset is five years, then the accumulated depreciation on the balance sheet is:
$5,500 x 5 = $27,500
So, after five years, the amount of accumulated depreciation also referred to as contra asset account, equals $27,000. The annual depreciation value of an asset increases by $5,500 each year, but the accumulated depreciation grows to $27,500.
Examples of depreciation methods
As mentioned above, the straight-line method isn’t the only way to calculate depreciation.
Using the same scenario from above, let’s see how the calculations work under each method.
A company has an asset worth $60,000, with a salvage value of $5,000. The useful life of the asset is 10 years. Adding to this, consider the depreciation rate of 20%, actual units equal to 5,000, and the estimated units produced equal to 100,000.
- Straight-line method: For this method, you can use the formula, (cost of the asset - salvage value) ÷ useful life to arrive at the depreciation value. Here's an example: ($60,000 - $5,000) ÷ 10 = $5,500.
- Declining balance method: Every year, the expenses will change based on the asset book value when using this method. The formula used here is, cost of the asset x depreciation rate. Here's an example: $60,000 x 20% = $12,000. Here, the first year’s depreciation value is $12,000. In the second year, the current book value of the asset would be $60,000 - $12,000, which is $48,000. The depreciation expense for this year would be, $48,000 x 20% = $9,600.
- Sum-of-the-years’ digits (SYD) method: The formula used under the SYD method is (remaining lifespan of the asset ÷ SYD) x (cost of the asset - salvage cost). If the SYD of the asset is 120, and the remaining lifespan is 15, we get: (15 ÷ 120) x ($60,000 - $5,000) = $6,875.
- Units of production method: The units of production depreciation formula is (cost of the asset - salvage value) ÷ (estimated lifespan units x actual units). Applying the formula, we get ($60,000 - $5,000) ÷ (100,000) x 2,000, which equals $1,100. Here, the first year’s depreciation expense is $1,100.
Following the accrued expenses method requires businesses to match the expenses it gets with revenue over each accounting period. Assets such as equipment contribute to revenue over various periods, and companies spread out the asset's cost over its useful life through depreciation. This gives way to depreciation expenses on the income statement over each accounting period.
Accumulated depreciation's effect on net income
During an asset’s useful life, depreciation is marked as a debit, while accumulated depreciation is marked as a credit. When an asset is removed from a company, its accumulated depreciation gets labeled as a debit and the overall value of an asset as a credit. Negative accumulated depreciation offsets the positive values of an asset.
Accumulated depreciation is not a cost. It’s a bookkeeping method that doesn’t affect the net income directly and doesn’t affect a company’s cash flow. Since it changes frequently, it does affect the valuation of a business.
On the other hand, depreciation expenses reduce net income when the asset’s cost is written on the income statement since it accounts for declines in the value of an asset over time.
Depreciation lets a company spread the cost of assets throughout its useful life, which does away with having to incur costs from being charged when the asset gets purchased. It’s an accounting practice that allows companies to make revenue from assets and pay for them over the time it is used. This is why depreciation expenses affect the net income of a company.
Accumulated depreciation vs. depreciation expense
Depreciation expense is the cost of owning an asset over a single reporting period. It gets reported in the form of debit on the income statement and gets applied against income. Depreciation expenses get used as a tax deduction method to reduce the taxable income.
On the other hand, accumulated depreciation is the total amount of depreciation expense associated with an asset from the beginning of its use. It appears on the income statement as credit and offsets fixed assets.
Amortization vs. depreciation
Amortization is an accounting practice that spreads the cost of intangible assets over their useful life. Intangible assets aren’t physical, but they have value.
Examples of intangible assets are:
- Patents
- Software
- Trademarks and copyrights
- Agreements
Amortizable costs are expensed on a straight-line basis. This means that the same amount gets expensed in each asset’s useful life period.
On the other hand, depreciation expenses fixed assets over their useful life. Fixed assets are tangible.
Some examples of tangible assets are:
- Machinery
- Building
- Equipment
- Furniture
- Vehicles
Unlike intangible assets, tangible assets have some value when the business doesn't use them anymore.
Adithya Siva
Adithya Siva is a Content Marketing Specialist at G2.com. Although an engineer by education, he always wanted to explore writing as a career option and has over three years of experience writing content for SaaS companies.
