Depreciation expenses of an asset that is accumulated over the years are called accumulated depreciation. Fixed assets have a carrying amount resulting from the difference between the cost of fixed assets minus accumulated depreciation of that asset and any possible impairment.
Accumulated depreciation is build up with the time once we start to depreciate an asset. As far as we keep depreciating assets, the contra account for the accumulated depreciation keeps increasing. As the name suggests, it’s accumulated with time and can reach up to the depreciable amount of an asset.
The depreciation is determined by deducting salvage value from the cost required to purchase and bring an asset in usable form.
The business may incur different costs in bringing an asset in the useable form, including installation, transportation, testing, etc.
Detailed understanding of the concept
Depreciation is the process of decreasing the face value of an asset over time due to its fair usage. It is possible to depreciate the overall cost and useful life of an asset in several ways.
Two primary depreciation methods are commonly used for calculating depreciation are,
- Straight-line method
- Reducing balance method
The purpose of applying these methods is to allocate the cost of an asset over its useful life. In simple words, we need to charge the expense of an asset in the periods of usage. Hence, the process of depreciation helps to ensure compliance with the matching concept of accounting.
It’s important to note that the impact of selecting a depreciation method is limited to the calculation of the depreciation charges. Once depreciation is calculated, it does not matter which method of accounting you’ve chosen. The rest of the treatment is the same in the books of accounts.
Treatment of Accumulated Depreciation in the financial statement
In the trial balance, the accumulated depreciation account is treated as a contra account. When it comes to the balance sheet, fixed assets are taken in by netting the Accumulated Depreciation. It means the net book value of an asset is shown in the financial statement, which is calculated as follows,
Netbook value = Cost of an asset – Accumulated depreciation (opening) – depreciation charges for a year – impairment charges (if any).
The given equation shows that depreciation expenses of an asset accumulated over the years are deducted from the asset’s cost capitalized to reach the net book value.
Journal entry for an accumulated depreciation
The journal entry for a single asset for calculating depreciation expense would be
|Accumulated Depreciation (Contra account accumulated over time)||XXX|
The Dr. Charge will lead the expense amount to the Profit and Loss account, or you may call it the Statement of Comprehensive Income.
On the other hand, Cr. charge will lead to the Balance sheet that will net off the particular Asset. Net off is necessary to present a true and fair view because we do not decrease depreciation from the cost of an asset.
Hence, we have to create a contra account on the credit side to net off the impact of the asset portion that has been used and charged in the income statement to date of depreciation.
It’s important to note that the cost of an asset is not modified during life in the cost model. Further, the asset is eliminated from books of accounts along with accumulated depreciation when an asset is sold.
The journal entry for multiple assets for calculating depreciation expense would be,
|Depreciation expense (asset-1)||XXX|
|Depreciation expense (asset-2)||XXX|
|Depreciation expense (asset-3)||XXX|
|Accumulated Depreciation (Contra account accumulated over time)||XXX|
Debit and credit impacts are the same as in the case of a single asset. However, this journal entry is used to record the depreciation of multiple assets.
Accounting software posts this type of entry when closing the accounting period in the fixed assets module. There can be several assets in the company.
The journal entry when Asset is sold at a loss would be,
|loss on disposal||XXX|
|Cost of asset||XXX|
The impact of the first debit is the elimination of accumulated depreciation from books of accounts. Since it’s a contra account balance and when we eliminate the associated capitalization of the Asset, we must also eliminate related contra account.
The second debit is to record a loss on the disposal of the assets. The loss is to be recorded when cash received/receivable/sales proceeds are less than the net book value of the assets. On the other hand, if the cash received/receivable/sale proceeds is higher than NBV, an income is recorded in the books of accounts as shown in the table.
The journal entry when Asset is sold at a profit would be,
|Gain on disposal||XXX|
|Cost of asset||XXX|
Gain on disposal is mapped as other income if the profit and loss and the last credit of the above journal entry remove the cost of an asset capitalized. It’s important to note that NBV is taken in the journal entry as a net off of the first debit and the last credit.
Let’s clear the concept of accumulated depreciation with the help of an example. Suppose we have an asset with an overall original,
Cost = $500,000
Useful life = 10 years
Scrape value = $100,000
Now by using both straight-line and reducing balance methods for calculating depreciation and the treatment of accumulated depreciation.
The formula for calculating Straight-line method is
Depreciation Expense = (Cost of an Asset – Scrap value at the end) / Useful life of an asset
= (500,000 – 100,000) / 10
= $40,000 per annum
Since depreciation per annum is $40,000, this amount of depreciation keeps adding in the following manner each year.
|Year||Per annum depreciation charges ($)||Accumulated depreciation ($)|
Note that in year 10, the accumulated depreciation has reached the highest point of depreciable amount. So, when accumulated depreciation reaches a depreciable amount, we do not need to charge depreciation anymore as the depreciable cost of an asset has already been charged in the income statement.
The same goes with the reducing balance method; the depreciation charged in the income statement keeps accumulating in the balance sheet. Further, it’s the same as the straight-line method. However, the difference is that there is more depreciation in the initial year of business than later.
Following are some of the advantages related to accumulated depreciation.
- Keeping track of all the depreciation transactions for the assets of the organization helps to maintain comprehensive accounting record.
- The depreciation process made life easy for all as allocation helps in allocation of the expense throughout useful life of an asset.
- With depreciation, expense tells you when to retire an asset of the organization. So, fixed assets plan can be designed.
- The company’s financial statements show the accumulated depreciation balance, which is credited with the annual depreciation figure. So, user of the financial statement can get fair idea about the volume of machinery etc.
- By obtaining this information, the company will be able to calculate the total depreciation charge that it has already incurred for its assets since the date of purchase;
- Accumulated depreciation is used for the calculation of profit/loss on disposal.
Following are some of the disadvantages related to accumulated depreciation.
- In organizations with many assets, recording every entry against assets related to the accumulated depreciation is time-consuming.
- As humans record the accumulated depreciation journal entry, there is the possibility of error.
Cash Flows and Depreciation
An asset was originally purchased for an amount that a company had a net cash outflow for, so everything related to it has been paid for. It is an expense, but it does not have a corresponding cash outflow, unlike most expenses. A capital lease is the one exception to this rule since the company seizes the Asset when it acquires it but accepts it on a lease basis over time.
- In the financial statement, you can find information about the costs of fixed assets, the addition of fixed assets, depreciation charges, and the total depreciated amount in the notes to financial statements. Asset wise break up is also provided for both leased and owned asset separately.
- Depreciation expenses accumulated over time will not be changed following the change in the depreciation method. This is because change in the depreciation method is change of an accounting estimates and treated retrospectively.
- The ending balance in the accumulated depreciation equals the amount charged under the depreciation during the year if there is no opening of accumulated depreciation.
Frequently asked questions
What’s the use of accumulated depreciation in the books of account?
Accumulated depreciation is used to calculate the Netbook value, which is taken as a closing figure in the balance sheet. Hence, accumulated depreciation helps present a true and fair view of the assets in front of management. Further, it helps management to make crucial decisions regarding the financial well-being of the organization.
When is accumulated depreciation removed from books of accounts?
Accumulated depreciation is removed from books of accounts when an asset is sold. It’s because it’s a contra account, which increases with Depreciation of the related Asset and is eliminated when sold.
How to determine the rate of Depreciation for PPE?
For the straight-line method, the life of an asset is taken and divided with the cost as the following formula.
Depreciation Expense = (Cost of an Asset – Scrap value at the end) / Useful life of an asset.
For the reducing balance method, the following formula is used to calculate the rate of depreciation.
Depreciation rate per year = 1/useful life of the Asset
Depreciation Value per year = (Cost of Asset – Salvage value of Asset)/ Depreciation Rate per Year