Like many accounting concepts, accumulated depreciation is a must-know to run your back office successfully. This notion plays hand in hand with depreciation itself and is vital to understand if you’re looking to grow your business.
What is Accumulated Depreciation?
Accumulated depreciation is the amount of total depreciation that has been allocated to a fixed asset since that asset was acquired and put into service.
To fully understand this concept, it is essential to first know what depreciation is as a general concept. Depreciation is a calculation used to reduce the value of a fixed asset over a specific period. This calculation directly relates to the length of the asset’s useful life, or how long a business owner thinks they’ll use an asset.
What Are the Main Types of Depreciation?
As a refresher, the four most common ways of depreciation are:
- Straight-line: This is the default method used to depreciate. It is calculated by dividing the difference between an asset’s cost and its expected salvage value by the number of years it is expected to be used.
- Double-declining balance: In this method, the asset is depreciated at twice the rate of the straight-line method, and the depreciation rate is calculated according to the remaining book value rather than the asset’s original value. This means that depreciation will be expensed higher in the early years and lower in later years, and the total depreciation expense over the life of the asset will remain the same.
- Units of production: This method uses a measure of an asset’s production output to determine the amount to be depreciated over a given time period. The amount of depreciation expensed will increase with the asset’s estimated usage.
- Sum-of-years-digits: This method takes the asset’s expected life and adds together the digits for each year it is used. Each digit is then divided by this sum, which determines the percentage by which the asset is depreciated in the given digit or year.
Although the straight-line method is the simplest and most common method of depreciation, accumulated depreciation will take place no matter which method is used to depreciate your assets.
What Type of Purchases Can Be Depreciated?
To depreciate an asset, it must have a lifespan of more than one year. For this reason, the type of assets that accumulate depreciation are assets that are capitalized. Capitalized assets are used in a company’s business operations to generate revenue for more than a single year and are not meant to be sold during the ordinary course of business. Examples of capitalized assets are property, plant, and equipment.
Operating assets, by contrast, will not be capitalized or have accumulated depreciation because they are expensed in the year they were purchased. This is due to the relevance of the assets diminishing within that same year. Examples of these assets are cash, inventory, accounts receivable, and fixed assets.
Where Can You Find Accumulated Depreciation?
You can find accumulated depreciation on the balance sheet. This is because accumulated depreciation cannot exceed the debit balance in the related asset account. Therefore it must be balanced as an asset account with a credit balance (otherwise known as a contra asset account). It will appear as a deduction from the gross amount of fixed assets reported. Accumulated Depreciation is credited whenever depreciation expense is debited each accounting period, resulting in an increasing credit balance on the balance sheet.
What Is the Formula For Accumulated Depreciation?
Calculating accumulated depreciation is a simple matter of running the depreciation calculation for a fixed asset from its acquisition date to its disposition date.
Accumulated Depreciation = Accumulated Depreciation at the Beginning of the Period + Depreciation Expense for the Period – Accumulated Depreciation on the Assets Disposed Of
Overall, you add depreciation expense charged during the current period to the accumulated depreciation at the beginning of the period while subtracting the depreciated expense for a disposed asset.
Accumulated Depreciation Example
A software company purchases computer equipment for, $20,000 and determines the depreciation expense will be $5,000 for 4 years credited by $5,000 as depreciation expense is debited by the same amount with no salvage value at the end of its useful life. Each year the accumulated depreciation account will be credited by $5,000 as depreciation expense is debited by the same amount. Because it is on the balance sheet, the accumulated depreciation balance will keep accumulating. Therefore after 2 years, the balance in the accumulated depreciation will be $10,000 and the vehicle’s book value will be; 20,000 – (5,000 x 2) = $10,000.
What is Salvage Value and Where Does That Fit In Here?
Salvage value is essential to understand when discussing accumulated depreciation. The salvage value is the estimated amount expected to be received for an asset at the end of its life. If “salvage value” sounds unfamiliar to you, it is also known as terminal value, scrap value, residual value, or disposal value.
Salvage Value Example
To further understand this concept, we can use the same example as before. Say you purchased computer equipment for $20,000. Perhaps this machine has no more use for your company, but you can resell its parts for a total of $7,000. This $7,000 would be the salvage value of the computer. Then the total amount depreciated over its useful lifespan would be $13,000 ($20,000 – $7,000 = $13,000).
The real reason to discuss salvage is to understand how it plays a part in accumulated depreciation. As seen in the example above the estimated salvage value is deducted from the cost of the asset in order to correctly calculate the total amount of depreciation expense that will be reported. This means at the end of an asset’s useful life, you use the accumulated depreciation formula and if there is an amount left over it would be that asset’s salvage value.
Why Should Business Owners Care About Accumulated Depreciation?
Besides diminishing the original acquisition value of an asset from wear and tear, accumulated depreciation has massive importance. It can help determine where your business chooses to invest its money, as a particular asset’s value will be affected by its accumulated depreciation. It also helps determine capital gains or losses when an asset is sold or retired.
Finally, accumulated depreciation is vital for calculating the taxable gain on a sale. For example, any gain that is attributable to the depreciation taken during the asset’s life may be taxed at the higher ordinary tax rate in comparison to the standard capital rate.
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