Accumulated Depreciation on the Balance Sheet
Investing Lesson 4 - Analyzing an Income Statement
Accumulated depreciation on the balance sheet serves an important role in that it reduces the original acquisition value of an asset as that asset loses value over time due to wear, tear, obsolescence, or any other factor that might cause it to be worth less in the future than it was at the time of acquisition. You probably know this instinctively. After all, if a company bought $100,000 worth of computers in 1989 and never recorded any depreciation expense, the balance sheet would still show an asset worth $100,000.
Do you really think that computers so old, which wouldn't even run modern operating software, are worth anywhere near that amount? At most, you'd be lucky to get a few hundred dollars for scrap parts.
Nevertheless, an illustration will probably be the best way to walk you through the specifics of accumulated depreciation as it will probably make more sense once you see it in action.
How Accumulated Depreciation Finds Its Way Onto the Balance Sheet
Imagine you own a restaurant. You decide to expand your catering division and purchase a $50,000 delivery van to handle these new, larger orders. You have to use one of the depreciation methods you learned about in the income statement analysis guide; straight line depreciation, sum of the years depreciation, accelerated depreciation, or double declining balance depreciation. There are multiple ways to compare these depreciation methods so choosing the right one for you shouldn't be hard.
For now, we'll use the simplest: Straight line depreciation.
You pay for the van. As a result, $50,000 gets taken from the balance sheet's cash section and moved to the property, plant and equipment section to reflect the cash you gave the car dealer when you took title to the van. This shows up on the cash flow statement, too.
At the same time, the loss in value of the asset needs to be recorded each year. You assume the delivery van will have a salvage value of $5,000 at the end of 10 years. As a result, the income statement shows $4,500 per annum in depreciation expense [$50,000 initial value - $5,000 salvage value / 10 years = $4,500 annual depreciation], which will reduce your reported net income.
Each year, that $4,500 expense that shows up on the income statement has to be balanced somewhere. The other side of the accounting entry goes into a special type of sub-account located under property, plant, and equipment known as a "contra-account". The reason it is called a contra-account: Even though it appears on the asset side of the ledger, it has a balance that causes the parent account to be reduced in value.
After the first year, the balance sheet would look like this:
- Property, Plant & Equipment (Delivery Van) = $50,000
- Accumulated Depreciation = ($4,500)
- Net Property, Plant & Equipment (Delivery Van) = $45,500
The accumulated depreciation serves an important role here. Not only did it facilitate recording that $4,500 depreciation expense on the income statement to more accurately reflect profits, it reduces the carrying value of the van to $45,500 to reflect the first year of losses on the asset.
Pay Attention to a Company's Depreciation Policies
One lesson to be learned here is that the depreciation policies of asset-intensive businesses such as airlines are extremely important. An aggressive management can use overly generous depreciation assumptions about asset life expectancy or salvage value, resulting in artificially low depreciation expense on the income statement and, as a result, artificially low accumulated depreciation on the balance sheet. This causes net income to be higher than it is in economic reality and the assets on the balance sheet to be overstated, too, which results in an inflated book value. To see the specifics of depreciation charges, policies, and practices, you will probably have to delve into the annual report or 10K.
Accumulated depreciation is also important because it helps determine capital gains or losses when and if an asset is sold or retired.
Imagine if you ended up selling the delivery van for $47,000 at the end of the year. The carrying value of the asset is now $45,500 ($50,000 in the property, plant, and equipment account offset by $4,500 in the contra-account for a net balance of $45,500). You'd need to record a $1,500 capital gain ($47,000 selling price - $45,500 carrying value) when removing it from the balance sheet because your depreciation assumptions turned out to be different from economic reality.
Balance Sheets Will Often Show Net Accumulated Depreciation
When you look at a balance sheet, you aren't going to see the individual assets, but rather the consolidated assets; all of the office equipment, computers, furniture, fixtures, lamps, planes, trucks, railroad cars, buildings, land, and more. Many businesses don't even bother to show you the accumulated depreciation account at all. Instead, they show a single line called "Property, Plant, and Equipment - net". That "net" addendum is referring to the fact that the company has deducted accumulated depreciation from the purchase price of the company's assets and is showing you only the bottom-line.
Once the asset has become worthless or is sold, both it and the matching accumulated depreciation account are removed from the balance sheet. Any gain or loss above the book value, or carrying value, is recorded according to specific accounting rules depending on the situation as previously demonstrated in our delivery van illustration.