Accumulated depreciation on the balance sheet serves an important role in capturing the current financial state of a business. It represents the reduction of the original acquisition value of an asset as that asset loses value over time due to wear, tear, obsolescence, or any other factor.
- Accumulated depreciation gives an accurate representation of the value of a company's assets over time.
- There are four different depreciation methods, and which you choose will depend on your business's structure and finances.
- Incorrectly calculating depreciation can inflate net profits on a balance sheet, as well as distorting capital gains or losses when an asset is sold.
- Most businesses list assets, including depreciation, in one line on their balance sheet labeled "Property, Plant, and Equipment—Net."
Why It's Important
Suppose a company bought $100,000 worth of computers in 1989 and never recorded any depreciation expense. The firm's balance sheet would still show an asset worth $100,000. Your common sense would tell you that computers that old, which wouldn't even run modern operating software, are worth nothing remotely close to that amount. At most, you'd be lucky to get a few hundred dollars for scrap parts. This company's balance sheet does not portray an accurate picture of its financial state.
In reality, the company would record a gradual reduction in these computers' value over time—their accumulated depreciation—until that value eventually reached zero.
Accumulated depreciation helps a business accurately reflect its profits and total value over time.
The following illustration walks through the specifics of accumulated depreciation, how it's determined, and how it's recorded in the financial statements.
Adding an Asset to the Balance Sheet
Imagine you own a restaurant. You decide to expand your catering division, so you purchase a $50,000 delivery van to handle new, larger orders. You need to use one of the accepted depreciation methods:
- Straight-line depreciation
- Sum of the years' digits depreciation
- Accelerated depreciation
- Double declining balance depreciation
There are multiple ways to compare these depreciation methods to find the method that best fits your business. In this example, we'll follow the standard straight-line depreciation method.
When you pay $50,000 cash for the van, that total amount gets taken from your company's balance sheet 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. That cash has been converted into a fixed asset. This shows up on the cash flow statement, too.
Recording Accumulated Depreciation
Once you own the van and show it as an asset on your balance sheet, you'll need to record the loss in value of the vehicle each year. You assume that 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 year in depreciation expense.
$50,000 initial value – $5,000 salvage value = $45,000
$45,000 / 10 years = $4,500 annual depreciation
This will reduce your reported net income by $4,500 each year.
The basic formula for straight-line depreciation is:
(Asset Purchase Value – Estimated Salvage Value at the End of Useful Life of Asset) / Useful Life of Asset
The $4,500 depreciation expense that shows up on each year's income statement has to be balanced somewhere, due to the nature of double-entry accounting. The other side of the accounting entry goes into a special type of sub-account located under the balance sheet's property, plant, and equipment account, known as a "contra-account." Even though it appears on the asset side of the ledger, this account has a balance that causes the parent account to be reduced in value (hence the "contra" in the name).
After the first year, the balance sheet would look like this:
- Property, Plant, and Equipment (Delivery Van) = $50,000
- Accumulated Depreciation = ($4,500)
- Net Property, Plant, and 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, but it also reduces the carrying value of the van to $45,500 to reflect the first year of losses on the asset.
Maintaining Accurate Depreciation Records
The depreciation policies of asset-intensive businesses such as airlines are extremely important. An aggressive management team 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, inflated profits and unrealistically 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 inflated book value. To see the specifics of depreciation charges, policies, and practices, you will probably have to delve into the annual report or 10-K.
Accumulated depreciation is also important because it helps determine capital gains or losses when and if an asset is sold or retired. Imagine that you ended up selling the delivery van for $47,000 at the end of the year. In this case, you'd need to record a $1,500 capital gain.
$47,000 selling price – $45,500 carrying value = $1,500 gain
When the time came to remove the van from your balance sheet, your assumptions about depreciation turned out to be different from economic reality. Capital gains (or losses) record this difference.
Net Accumulated Depreciation
When you look at a balance sheet, you probably aren't going to see the individual assets, but rather the consolidated assets—a sum total of all 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 result.
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 the delivery van illustration.