What is Accumulated Depreciation?
Accumulated depreciation refers to the total amount of depreciation that a business asset has accumulated over its useful life. It is a contra-asset account, which means it has a structure opposite to that of a normal asset account.
Key Points
- Depreciation links the cost of using a long-term asset to the benefits it yields over its useful life.
- Accumulated depreciation is the sum of all depreciation charged against an asset up to a specific date.
- Accumulated depreciation appears below the asset section on the balance sheet.
- Accumulated depreciation is a contra-asset account, opposite to the structure of a normal asset account.
- The book value of an asset is its historical cost minus accumulated depreciation.
Understanding Accumulated Depreciation
According to the Generally Accepted Accounting Principles (GAAP), expenses must match the revenues they help generate in the same accounting period. Depreciation allocates the cost of an asset over its useful life, ensuring that the asset's cost is expensed each year as it is used to generate revenue.
Accumulated depreciation is the total depreciation of an asset up to a specific point in time. Each period's depreciation is added to the beginning balance of accumulated depreciation. The book value of an asset on the balance sheet is its historical cost minus accumulated depreciation. At the end of an asset’s useful life, its book value will match its salvage value.
When recording depreciation in the general ledger, businesses debit depreciation expense and credit accumulated depreciation. Depreciation expense affects the income statement, while accumulated depreciation appears under the asset section on the balance sheet. As accumulated depreciation increases over time, the book value of the asset decreases. The book value after depreciation depends on the salvage value, which is the expected amount the company will receive from selling the asset at the end of its useful life.
How to Calculate Accumulated Depreciation?
Accumulated depreciation is calculated using several accounting methods, including the straight-line method, declining balance method, double declining balance method, and units of production method. Generally, the method chosen divides the depreciable base of the asset by an appropriate divisor, such as useful years or units produced. Here are some common methods for calculating accumulated depreciation.
- Straight-Line Method: The company deducts the salvage value from the purchase price to obtain the depreciable base, which is then evenly divided over the asset's expected useful life. The formula is: Annual Accumulated Depreciation = (Asset Cost - Salvage Value) / Useful Life. For example, if ABC Company buys a building for $250,000 with a useful life of 20 years and a salvage value of $10,000, the depreciable base is $240,000. Over 20 years, the company will record $12,000 of accumulated depreciation each year.
- Declining Balance Method: Depreciation is calculated as a percentage of the asset's current book value. The percentage remains the same each year, but since the book value decreases, the depreciation amount decreases each year. The formula is: Annual Accumulated Depreciation = Current Book Value * Depreciation Rate. For instance, if ABC Company buys a vehicle for $10,000 with no salvage value and opts for a 20% depreciation rate, the first year's depreciation is $2,000 (20% of $10,000). The next year's depreciation is $1,600 (20% of the remaining $8,000).
- Double Declining Balance Method (an accelerated depreciation method): The company first calculates the depreciation amount using the straight-line method and doubles the depreciation rate, applying it consistently each year until the salvage value is reached. The rate can be calculated as 100% divided by the useful life, then doubled. The formula is: 1. Double Declining Balance Rate = (100% / Useful Life) * 2. 2. Double Declining Balance = Depreciable Amount * Double Declining Balance Rate. For example, if ABC Company buys a building for $250,000 with a $10,000 salvage value, under the straight-line method, the double declining rate is 10% (100% / 20 years * 2). Using 10%, the company records $24,000 of depreciation in the first year (10% of $240,000), and $21,600 in the second year ((240,000 - 24,000) * 10%).
- Sum-of-the-Years-Digits Method: The company seeks to charge higher depreciation in the early years and lower amounts later. This method is calculated by adding the digits of the useful years and depreciating based on the reverse of the sum of the years' digits. The formula is: Annual Accumulated Depreciation = Depreciable Base * (Remaining Useful Life / Sum of the Years' Digits). For instance, if ABC Company buys equipment with a 5-year useful life and a depreciable base of $15,000, the sum of the years' digits is 15 (5+4+3+2+1). Depreciation for the first year is $5,000 (5/15 of $15,000). In the second year, it is $4,000 (4/15 of $15,000).
- Units of Production Method: The company estimates the total productive capacity of an asset and variably charges depreciation based on units produced each year. The formula is: Annual Accumulated Depreciation = (Units Consumed / Total Units) * Depreciable Base. For example, a company buys a vehicle and plans to drive it 80,000 miles. In the first year, it drives the vehicle 8,000 miles, recording 10% of the depreciable base. If in the second year 20,000 miles are driven, 25% is recorded for that year. Accumulated depreciation now stands at $28,000 (first-year $8,000 + second-year $20,000).
Accumulated Depreciation vs. Accelerated Depreciation
- While they sound similar, accumulated depreciation and accelerated depreciation are distinct accounting concepts. Accumulated depreciation refers to the total reduction in the book value of an asset to date, while accelerated depreciation is a method that records higher depreciation expenses in the early years of an asset's useful life.
- Since accelerated depreciation is a method of recording depreciation, it causes accumulated depreciation to increase more quickly in the initial years. The rationale is that new assets (e.g., new company vehicles) are typically utilized more than older ones.
Accumulated Depreciation vs. Depreciation Expense
When an asset is depreciated, it affects both accumulated depreciation and depreciation expense. There are two main differences between the two: Depreciation expense is reported on the income statement, whereas accumulated depreciation is reported on the balance sheet. Depreciation expense is recalculated each year, while accumulated depreciation is the total amount over the asset's useful life.
Special Considerations
Accounting Adjustments/Changes in Estimates
Since the process of depreciation is largely based on estimates, companies often need to revise their estimates regarding an asset's useful life or salvage value. Such revisions are treated as changes in accounting estimates, not changes in accounting principles. For example, suppose a company depreciates an asset with a cost of $10,000 and no salvage value over five years using the straight-line method, recording $2,000 in accumulated depreciation annually.
After two years, the company realizes the remaining useful life is six years instead of three. According to GAAP, the company does not retroactively adjust its financial statements; it only adjusts the annual accumulated depreciation amount going forward.
In this scenario, with a net book value of $6,000 (original $10,000 less $4,000 accumulated depreciation), the company will recognize $1,000 in accumulated depreciation annually over the next six years.
Half-Year Convention
A common depreciation strategy is to allocate half a year’s depreciation in the year of acquisition and the final year of the asset’s useful life. This approach aims to fairly distribute depreciation expense and accumulated depreciation.
For example, if Company A purchases a vehicle with a five-year useful life, the company will recognize six months of depreciation in the first year, regardless of the acquisition month. It will record full-year depreciation from the 2nd to 5th years and the final six months in the 6th year. Although the asset has a five-year useful life, it effectively sees use during the first and sixth years.
Is Accumulated Depreciation an Asset?
Accumulated depreciation is a contra-asset account, meaning it is structured opposite to a normal asset account. It has a natural credit balance and is reported in the asset section of the balance sheet.
Is Accumulated Depreciation a Current Liability?
No, accumulated depreciation is not a liability. A liability is a future financial obligation that a company must pay (such as debt). Accumulated depreciation is a method for recognizing depreciation over time, not a cash outflow or a one-time expense.
Is Accumulated Depreciation a Credit or Debit?
Accumulated depreciation has a natural credit balance. Although it appears under the asset section on the balance sheet, it reduces the total value of assets recognized in financial statements.
Summary
Many companies rely on capital assets such as buildings, vehicles, equipment, and machinery to conduct their operations. According to accounting standards, companies must depreciate these assets over their useful lives. Therefore, companies must recognize accumulated depreciation, which is the total of depreciation expenses charged over the asset's useful life.
