Accumulated Depreciation on Balance Sheet
Accumulated depreciation on balance sheet reflects the total decrease in the value of an asset over time. The values of all assets of any type are reported on the balance sheet with the accumulated depreciation recorded over the years of useful life. One can find accumulated depreciation on balance sheet presented just below the related capital asset line.
What is accumulated depreciation?
Unlike the usual asset account, a credit to a contra asset account brings about an increase in its value while a debit brings about a decrease in its value. Whenever a depreciation expense is recorded for an organization, the same amount is also credited to the accumulated depreciation account which allows the company to indicate both the asset’s cost and its total-to-date depreciation. This also shows the net book value of the asset on the balance sheet.
In order to track an asset’s total depreciation over its life, financial analysts will create a depreciation schedule. With this, the intent behind charging depreciation over a fixed asset is to approximately match the revenue or other benefits that the asset generated to its cost over its useful life. This is known as the matching principle.
Under the generally accepted accounting principles (GAAP), the matching principle dictates that expenses have to be matched to the same accounting period in which the related revenue is generated. It is through depreciation that a business will expense a portion of a capital asset’s value over each year of its useful life. This implies that each year, a capitalized asset is put to productive use thereby generating revenue, and the cost that is associated with using up the asset is recorded.
There will be an increase in the amount of accumulated depreciation over time as depreciation continues to be charged against the asset. The asset,s original cost is referred to as its gross cost, while the asset’s original cost less the amount of accumulated depreciation and other impairment charges is known as its net cost or carrying amount.
As earlier stated, the accumulated depreciation account is a contra asset account, which is an asset account with a credit balance. When the retirement or sale of this asset takes place, there is a reverse in the amount of the accumulated depreciation account relating to the asset as is the asset’s original cost, thereby eliminating all records of the asset from the company’s balance sheet. If this derecognition were not completed, a company will gradually build up a large amount of the gross cost of fixed assets and accumulated depreciation on its balance sheet.
In the course of recording depreciation in the general ledger, a company debits depreciation expense and credits accumulated depreciation. Depreciation expense flows through the income statement during the period in which it was recorded. Accumulated depreciation is usually presented on the balance sheet under the line for related capitalized assets. The balance of the accumulated depreciation increases over time as the amount of the depreciation expense recorded in the current period is added.
There will be an increase in the amount of accumulated depreciation account more quickly if the business makes use of an accelerated depreciation methodology. This is because doing so charges more of an asset’s cost to expense during its earlier years of usage. The use of accelerated depreciation methodology makes it more difficult to judge how old the fixed assets of the reporting entity are since the proportion of accumulated depreciation to fixed assets is greater than the case would normally be.
See also: Return on Assets Formula: ROA Calculation
Accumulated depreciation on balance sheet and book value
Financial analysts use accumulated depreciation to calculate the net book value of an asset which is the value of an asset carried on the balance sheet. The net book value is calculated by subtracting the accumulated depreciation from the cost of an asset.
For example, if a company purchased a piece of machinery for $150,000 and the accumulated depreciation is $40,000, then the net book value of the machinery will be $110,000, that is,
NBV = $150,000 – 40,000
NBV = $110,000
How to calculate accumulated depreciation on balance sheet
- Straight-line method
- Declining balance method
- Sum-of-the-years’ digits (SYD) method
- Units of production method
The definition of accumulated depreciation is calculated by summing up the depreciation expense amounts for each year.
Many companies depend on capital assets like buildings, machinery, equipment, and vehicles as part of their daily operations. According to the accounting rules, it is required for companies to depreciate these assets over their useful life. As a result, companies have to recognize accumulated depreciation which is the sum of depreciation expenses recognized over the life of an asset. Accumulated depreciation on balance sheet is recorded as a contra asset that brings about a reduction in the net book value of the capital asset section. However, the different methods of depreciation allowed by GAAP will be explained with examples.
Straight-line method
Under this method of depreciation, a company subtracts the salvage value also known as the scrap value or residual value from the cost or purchase price of the asset to find a depreciable base. This base is then accumulated evenly over the estimated years of useful life. In other words, it gives a report showing an equal amount of depreciation expense annually throughout its entire lifespan of use until the entire asset is depreciated to its scrap value.
The straight-line method of depreciation is the most basic way. When the asset’s scrap value is subtracted from its cost, the remaining amount becomes the depreciable cost. It is the depreciable cost that becomes the total depreciation amount that a company must expense in equal amounts over the estimated years of the useful life of the asset.
The formula for the straight-line method is;
Accumulated depreciation = Cost – residual value / years of useful life
Example
Let us look at this example. A company purchased equipment for $60,000, its scrap value is $5,000 and its useful life is 5 years. The depreciation rate is 20% and the estimate for the units to be produced over the lifespan of the assets is 100,000 but the actual units produced is 5,000
To calculate the depreciation using the formula;
Dep = Cost – residual value / years of useful life
= ($60,000 – $5,000) / 5
= 55,000 / 5
= $11,000
Based on the assumption, the depreciable amount will be $55,000, that is $60,000 cost minus $5,000 scrap value. Therefore, $11,000 will be the annual depreciation expense.
The depreciation rate can be calculated from this result as;
Depreciation rate = $11,000 / 55,000 x 100
= 0.2 x 100 = 20%
Declining balance method
Under the declining balance method, the depreciation will be recorded as a percentage of the asset’s current book value. The depreciation amount decreases each year because the same percentage is used every year while the current book value decreases. Although accumulated depreciation will still increase, the amount of accumulated depreciation will decrease each year. The formula is as follows;
Accumulated depreciation = Current book value x depreciation rate
Example
Using the example above, the cost of the equipment is $60,000, its scrap value is $5,000, its useful life is 5 years. The depreciation rate is 20% for each year while the depreciation expense for the first year is $11,000.
For the second year, the calculation using the depreciation rate will be;
Dep = Current book value x depreciation rate
= ($55,000 – $11,000) x (20/100)
= $44,000 x 0.2
Dep = $8,800
The same principle can be applied to the subsequent years and with this, one can easily notice that with each year, the balance keeps decreasing.
Double declining balance method
The double-declining balance method is also referred to as accelerated depreciation. Here, after calculating the depreciation under the straight-line method, the depreciation rate will be multiplied by two (or doubled). This rate is then kept the same across all years the asset is depreciated and this continues to accumulate until the salvage value is arrived at.
Accumulated depreciation = 2(SLDP×BV)
where,
SLDP = Straight-line depreciation rate
BV = Book value at the beginning of the period in terms of years
Example
Still using the information above to carry out the calculation, we will use the formula which is;
Dep. = 2(SLDP×BV)
Dep. = 2 [20% x ($55,000 – $11,000)]
= 2 (0.2 x $44,000)
= 2 (8,800)
Dep. = $17,600
Apply this principle to subsequent years and sum the values up to get the accumulated depreciation which will be recorded on the balance sheet.
Sum-of-the-years’ digits (SYD) method
Under the SYD method, the company looks towards recording more depreciation earlier in the life of the asset and less in later years. Here, the digits of the expected years of useful life are summed up then depreciation takes place on the basis of each number of years. For a better understanding, a table will be created to carry out this calculation.
| Years | Dep. base ($) | Equipment’s remaining life | Dep. fraction | Display of calculation | Dep. expense ($) |
|---|---|---|---|---|---|
| 1 | 55,000 | 5 | 5/15 | (5/15) x 55,000 | 18,333 |
| 2 | 55,000 | 4 | 4/15 | (4/15) x 55,000 | 14,667 |
| 3 | 55,000 | 3 | 3/15 | (3/15) x 55,000 | 11,000 |
| 4 | 55,000 | 2 | 2/15 | (2/15) x 55,000 | 7,333 |
| 5 | 55,000 | 1 | 1/15 | (1/15) x 55,000 | 3,667 |
| ∑ | 15 | 55,000 |
As seen in the table above, the depreciation base was derived from subtracting the scrap value from the initial cost of the equipment, which is $60,000 – $5,000 = $55,000. Secondly, the year digits, 1 to 5, were summed up, that is, 1+2+3+4+5 = 15, the equipment’s remaining life was then displayed starting from year 5 as seen in the third column above. From there, the depreciation expense was calculated using each year digit divided by the sum of the year digit multiplied by the depreciation base.
Units of production method
Under this method of depreciation, the total useful output of an asset is estimated. It requires an estimate of the total units that an asset will produce in its useful life. The depreciation expense is calculated annually based on the number of units produced. The units of production method also calculate depreciation expenses based on the depreciable amount. It assigns an equal expense rate to each unit that is produced. In turn, this makes it most useful for the assembly of production lines. The formula involves the use of historical costs which is the asset’s price based on its nominal and original cost when the company acquired it and estimated its residual value. This method is then the factor that determines the expense for the accounting period multiplied by the number of units produced.
The formula used in the units of production method is as follows;
Depreciation expense (unit) = (Fair value – residual value) / useful life (in units)
Usually, analysts make use of this method of depreciation in mining operations. Note that salvage value, scrap value, and residual value mean the same thing as they are used interchangeably.
Example
In the example we have been using, the cost of the equipment is $60,000, its scrap value is $5,000, and its useful life is 5 years. The estimated units of production over the useful life of the asset is 5,000.
Using the formula;
Depreciation expense = (Fair value – residual value) / useful life (in units)
= ($60,000 – $5,000) / 10,000
= 55,000 / 10,000
Depreciation expense = $5.5 per unit
Accumulated depreciation depends on salvage value and the salvage value is determined as the amount that a company may expect to receive in exchange for selling an asset at the end of its useful life.
See also: Common Stock: Asset or Liability?
Effect of accumulated depreciation on balance sheet
Depreciation is an expense, so it can be quite difficult to have an understanding of how it can affect the balance sheet. It is a noncash expense that writes off the value of assets over time. Due to the matching principle, accountants prefer to write off their assets’ value as they are used over time. The write-down takes place on the balance sheet with the line items depreciation expense and the contra account, accumulated depreciation. Certainly, we cannot talk about accumulated depreciation on balance sheet without talking about depreciation expense. We can say that accumulated depreciation changes the value of assets on the balance sheet.
The balance sheet provides information to the reader with the value of total assets and shows how the purchase of those assets took place, with either debt or equity. As the value of assets decreases as a result of usage, it is written off on the balance sheet. As previously stated, the accumulated depreciation is the contra account for depreciation, the account that holds the value of asset depreciation over time.
During the useful life of an asset, depreciation is marked as a debit while accumulated depreciation is marked as a credit. When the asset is then removed from the company, its accumulated depreciation will be labeled as a debit and the asset’s overall value as a credit. A negative accumulated depreciation value offsets an asset’s positive values.
One should note that accumulated depreciation is not a cost, it is rather a bookkeeping method that has no direct effect on the net income and also has no effect on the company’s cash flow. Since it experiences frequent change, it has no effect on the valuation of a business.
Depreciation expense on the other hand brings about a reduction in net income when the cost of the asset is written on the income statement since it accounts for declines that take place in the value of assets over time.
Depreciation allows a company to spread the cost of its assets throughout its useful life. This helps in doing away with having to incur costs from charges that may be attracted when the asset is purchased. In accounting practice, this allows companies to make revenue from assets and pay for them over the time it is used. It is here that depreciation expenses affect a company’s net income.
Why is accumulated depreciation a credit balance?
Fixed or noncurrent assets have a debit balance on the balance sheet and by recording accumulated depreciation as a credit balance, the fixed assets can be offset. In other words, accumulated depreciation offsets the value of the asset that is being depreciated. As a result of this, accumulated depreciation is a negative balance that is recorded on the balance sheet under the fixed assets section.
However, a company reports its fixed assets on the balance sheet at their original cost, accumulated depreciation is also recorded thereby allowing investors to see the value of the fixed asset that has been depreciated as well as its net book value.
By allowing accumulated depreciation to be recorded as a credit, it is easy for investors to determine the original or initial cost of the fixed asset, the amount of depreciation, and the asset’s net book value.
At the sale or retirement of an asset, the total accumulated depreciation that has to do with that asset is reversed thereby completely removing the record of the asset from the books of a company.
See also: Assets, Liabilities, Equity: Comparison
Accounting adjustments and changes in estimate
As a result of the fact that the depreciation process is heavily rooted in estimates, it is common thing for the company to need to revise their guess on the useful life of an asset or the salvage value at the end of the asset’s useful life. This change reflects a change in accounting estimate and not a change in accounting principle. For example, if the company was depreciating a $10,000 asset over its useful life of five years without any salvage value, making use of the straight-line method, accumulated depreciation of $2,000 is recognized.
If after two years, the company realizes the remaining useful life which became six years instead, under GAAP, there will be no need for the company to retroactively adjust financial statements for changes in estimates. The company will rather change the amount of accumulated depreciation recognized annually.
In the example, since the net book value of the asset is now $6,000 ($10,000 – $4,000 of accumulated depreciation recorded in the first two years) in the next six years, the company will now recognize $1,000 of accumulated depreciation for the next six years.
Accumulated depreciation vs depreciation expense
It is important to note that when an asset is depreciated, there are two accounts that are immediately impacted, the accumulated depreciation and the depreciation expense. As earlier stated, the journal entry for recording depreciation results in a debit to depreciation expense and a credit to accumulated depreciation.
The key difference between accumulated depreciation and depreciation expense is the fact that depreciation expense is recorded on the income statement while accumulated depreciation is recorded on the balance sheet.
Another difference is the fact that the income statement does not carry from year-to-year. Activity is swept to retained earnings and a company moves to reset its income statement every year, its balance sheet, meanwhile, is a life-to-date running total that does not clear at the end of the year. Having said this, depreciation expense is recalculated yearly whereas accumulated depreciation is usually a life-to-date running total.
Accumulated depreciation is used to calculate the adjusted basis for the tax in order to determine its taxable gain on the sale of the asset. On the other hand, depreciation expense is used as a tax deduction to reduce taxable income.
The amount of accumulated depreciation is reversed when the asset is sold or put out of use, while for depreciation expense, the allocation of expense is ended when the asset is sold or put out of use.
Accumulated depreciation vs accelerated depreciation
Although accumulated depreciation and accelerated depreciation sound similar in name, they refer to two different accounting concepts.
While accumulated depreciation refers to the life-to-date depreciation that has been recognized that brings about a reduction in the book value of an asset, accelerated depreciation on the other hand refers to a method of depreciation where the higher depreciation amount is recognized earlier in the life of an asset.
Since accelerated depreciation is an accounting method of charging depreciation on assets, the result of it is to book accumulated depreciation. In this method, the amount of accumulated depreciation accumulates faster at the early stage of the asset life and accumulates slower at the later stage of the asset’s life. The philosophy behind accelerated depreciation is that newer assets such as a company vehicle are usually used more than older assets because they are in better condition and more efficient.
