Accumulated Depreciation – Why Is This Important For Businesses?
Accumulated depreciation is the cumulative depreciation of an asset up to a single point in its life. This form of depreciation is a contra-asset account, meaning its natural balance is a credit that reduces the overall asset value.
To learn more about this form of depreciation and how it’s calculated, read this post till the end.
What Is The Purpose Of Accumulated Depreciation?
Accumulated depreciation is the total amount an asset has been depreciated up until a single point. Each period, the depreciation expense recorded in that period is added to the beginning accumulated depreciation balance.
An asset’s carrying value on the balance sheet is the difference between its historical cost and the accumulated depreciation. At the end of an asset’s useful life, its carrying value on the balance sheet will match its salvage value.
How To Calculate Accumulated Depreciation?
As of now, there are five different ways to calculate all forms of depreciation under GAAP (Generally Accepted Accounting Principles). These five methods (with formulas and examples) are:
1. Straight Line Method
In this method, the salvage value of an asset is estimated when the asset is bought. Here, an appraiser is hired to apprise the asset so that its final salvage value after its useful lifespan can be calculated.
Therefore, now that the final salvage value of the asset gets calculated, it now becomes easier to calculate depreciation. All you have to do is subtract the salvage value from the initial book value of the asset. Here’s the formula for straight line depreciation:
| Annual Accumulated Depreciation = (Asset Value – Salvage Value) / Useful Life In Years |
Here’s an example of this formula in action:
| Let’s suppose you buy a laptop for $2000. This laptop is expected to be useful for four years. After appreciating it, its salvage value (at the end of the fourth year) is estimated to be $500. Therefore, the accumulated depreciation will be = ($2000 – $500) / 4 = $375 |
2. Declining Balance Method
As per this method, your assets depreciate at a fixed rate (depreciation percentage) every year. Therefore, since the same rate of depreciation is taken into account, the amount of depreciation declines every year. However, this will increase accumulated depreciation every year.
Here’s the formula:
| Annual Accumulated Depreciation = Current Book Value x Rate of Depreciation |
Here’s how this formula is applied:
| Let’s suppose you buy a laptop for $2000. After its appreciation, it was estimated that it would depreciate by 20% every year. Therefore, the accumulated depreciation on Year 1 would be = $2000 x 20% = $500. Similarly, the accumulated depreciation for Year 2 would be = $1500 x 20% = $300. |
3. Double Declining Balance Method
The double declining balance method (also known as accelerated depreciation) is the same as the straight-line depreciation method. However, the only difference here is that the rate of depreciation is doubled here. The rate is kept the same across all useful years of the asset.
For the sake of simplicity, the rate of depreciation is twice 100%, which is divided by its useful life in years. Here’s the formula, divided into three steps:
| Double Declining Balance Method Rate = (100% / Useful life in years) x 2 Depreciable Base = Initial Amount – Salvage Value (for Year 1) Double Declining Balance Method Depreciation = Depreciable Base x Double Declining Balance Method Rate |
Here’s how this formula is applied:
| Let’s suppose you buy a laptop for $2000. This laptop is expected to be useful for four years. After appreciating it, its salvage value is estimated to be $500. Therefore, its double declining depreciation rate is 25% (100% depreciation / 4 years). Also, its depreciable base for Year 1 is $1500 (Initial price – salvage value). So, its double declining balance method rate will be 50%. Therefore, its depreciation amount in Year 1 would be = $1500 x 50% = $750. For Year 2, this would be = ($2000 – $750) x 50% = $625. |
4. Sum-Of-The-Years Digits Method
In this depreciation method, most of the depreciation is recorded at the start. Therefore, as it nears the end of its useful life, the depreciation recorded gets lower and lower. This calculation is done by adding up the digits of the useful years and then depreciating accordingly.
Therefore, the formula here is:
| Annual Accumulated Depreciation = Depreciable Base x (Inverse Number of years / sum of year digits) |
Here’s an example of how this works:
| Let’s suppose you buy a laptop for $2000. This laptop is expected to be useful for four years. So, the sum of year digits will be 4+3+2+1 = 10. Therefore, for Year 1, its depreciation will be = $2000 x (4/10) = $800. For Year 2, it will be = $1200 x (3/10) = $360. |
5. Units Of Production Method
In this depreciation method, the total output produced by the asset is considered. After that, the output consumed annually is then recognized.
Its formula is:
| Annual Accumulated Depreciation = (Number of consumed output / total units to be produced) x Depreciable Base |
Here’s an example:
| Let’s suppose you buy a laptop for $2000. This laptop is expected to be used for 8000 hours overall. In the first year, you used it for 2000 hours. Therefore, its Year 1 depreciation would be = (2000/8000) x $2000 = $500. For Year 2, if the same amount of hours is used (2000 hours), then it will be = (2000/8000) x $1500 = $375. |
Accumulated Depreciation – How Does It Compare To Other Forms Of Depreciation?
Compared to other forms of depreciation, here’s how accumulated depreciation differs:
1. Accumulated Depreciation Vs Accelerated Depreciation
Though similar sounding in name, accumulated depreciation, and accelerated depreciation refer to very different accounting concepts.
Accumulated depreciation refers to the life-to-date depreciation that has been recognized that reduces the book value of an asset.
On the other hand, accelerated depreciation refers to a method of depreciation where a higher amount of depreciation is recognized earlier in an asset’s life.
2. Accumulated Depreciation Vs Depreciation Expense
When an asset is depreciated, two accounts are immediately impacted: accumulated depreciation and depreciation expense. The journal entry to record depreciation results in a debit to depreciation expense and a credit to accumulated depreciation. The dollar amount for each line is equal to the other.
There are two main differences between accumulated depreciation and depreciation expense. First, depreciation expense is reported on the income statement, while accumulated depreciation is reported on the balance sheet.
Second, on a related note, the income statement does not carry from year-to-year. Activity is swept to retained earnings, and a company “resets” its income statement every year. Meanwhile, its balance sheet is a life-to-date running total that does not clear at year-end. Therefore, depreciation expense is recalculated every year, while accumulated depreciation is always a life-to-date running total.
Bottom Line
Many companies rely on capital assets such as buildings, vehicles, equipment, and machinery as part of their operations. In accordance with accounting rules, companies must depreciate these assets over their useful lives.
As a result, companies must recognize accumulated depreciation, the sum of depreciation expense recognized over the life of an asset. Accumulated depreciation is reported on the balance sheet as a contra asset that reduces the net book value of the capital asset section.
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