A company’s balance sheet is a snapshot of financial health at a point in time. Assets, liabilities, and shareholder’s equity is recorded in the balance sheet. In the long-term assets, there are tangible and intangible assets. Each asset and liability is recorded to depict its present value adjusted for any allowance or deduction.
Fixed assets are depreciated over time, and intangible assets are amortized over life. Imagine an ice-cream vendor. He bought the ice cream truck, and that truck helps him to earn money. The truck is going to help him earn income over the years. And consequently, some parts of the truck will become obsolete- decreasing the economic life.
According to the matching principle of accounting, you cannot record the truck’s cost in one year’s income statement. However, the cost will be spread over the number of years you will use the truck. This method of writing off an asset’s cost is known as depreciation. We will discuss the concept of accumulated depreciation, its recognition, and measurement in the balance sheet of a business.
What Is Accumulated Depreciation?
Let’s define depreciation first.
The periodic allocation or writing off of a depreciable asset’s cost to expense over its useful life is termed depreciation.
The International Accounting Standards(IAS 16) defines depreciation as,
The systematic allocation of the cost of a depreciable asset to expense over the asset’s useful life.
The accumulated depreciation can be defined as,
‘It is the sum of all periodic installments of depreciation expense over the useful life of a tangible asset.’
Accumulated depreciation adds up all the periodic depreciation of a specific asset from the time it was brought into use. More appropriately, accumulated depreciation can be categorized as a contra-asset account that offsets the asset account’s balance.
Understanding Accumulated Depreciation
The matching principle of accounting explains when an expense should be realized. In any business, expenses are incurred to generate revenues. Any cost incurred by a business to earn an income should be offset against that revenue. In other words, the recording of incomes and expenses should be done on a cause-and-effect basis.
Therefore, the depreciation on tangible assets is calculated to follow the matching principle. Whereas the accumulated depreciation account recognizes the total amount of depreciation realized to the date of balance sheet preparation.
Every year, the periodic depreciation is added to the year-beginning accumulated depreciation account. The entry for the realization of periodic depreciation in ledger accounts is made by crediting accumulated depreciation against depreciation expense. Since the accumulated depreciation is a contra-asset account for different tangible assets, it plays a vital role in the appropriation of an asset’s value in the balance sheet.
In most accounting methods, assets are recorded at the original cost in the balance sheet. However, the accumulated depreciation allows assets to deduct the deterioration from the original cost. It is recorded under respective assets as a negative balance in the balance sheet.
Accumulated depreciation also gives useful insights for the investors and stakeholders analyzing the financial statements. It dictates how much of the asset has been used; hence book value of an asset can be estimated.
Recognition Of Accumulated Depreciation: Which Assets Are Depreciated?
Tangible assets are physical assets that can be touched –think of plant, land, machinery, your laptop, building, office stationery. Intangible assets are non-physical assets that cannot be touched or felt –a business’s goodwill, patents, copyrights, brand value, etc.
Depreciable assets are physical assets, but not all physical assets are depreciable. For instance, the one characteristic of a depreciable asset is that it does not lose its shape and size. However, the asset becomes obsolete or less useful over time.
The second characteristic of the depreciable asset is that you cannot physically consume it. Think of office supplies. The economic utility of the depreciable asset is decreased, however.
By the characteristics of depreciable assets, we can define them as
Depreciable assets provide economic benefits for more than one accounting period. These assets cannot be physically consumed or lose their shape. However, the economic usefulness of these assets declines over time.
Examples of depreciable assets are:
- Furniture and Fixtures
Land is not a depreciable asset because it does not fulfill all characteristics of a depreciable asset. The land does not lose its shape, and it cannot be physically consumed. But, the other characteristic of becoming obsolete or less useful does not hold for land. Therefore, it is not treated as a depreciable asset.
Measurement Of Accumulated Depreciation
For recognition and measurement of accumulated depreciation, it is important to understand some facts about depreciation. The depreciation or accumulated depreciation of an asset has the following principles for measurement and recognition in books of accounts.
Depreciation is not a valuation method.
Most people often confuse depreciation as the valuation of the asset’s market value every year. However, the case is the opposite. Depreciation is the process of cost allocation instead of asset valuation.
An asset’s depreciation has nothing to do with its market value. Book value is considered for calculating depreciation on any asset. Book value is the cost of the asset minus the depreciation every year.
Residual Value And Useful Life
The whole depreciation mechanism works on two important aspects of any tangible asset: an asset’s useful life and its residual value after economic life.
The estimated useful life is an important measure that determines the cost written off for every accounting period. If the useful life is longer, you will write off a lower cost every year and vice versa.
Any asset’s residual value is carrying value or salvage value at the end of the useful life. A business calculates the residual value of assets to estimate what it can receive in exchange for an asset at the end of its useful life.
When a business depreciates its assets, a certain method of depreciation is adopted. According to the regulations for financial disclosures, a business must use consistent accounting methods. The principle of consistency also applies to writing off an asset in terms of depreciation.
Although, it is encouraged to use different depreciation methods for different assets. However, there should be consistency in the methods. For instance, you depreciate certain equipment over the straight-line method. The method should be consistent throughout the life of that equipment.
Whereas different depreciation methods might be used for accounting purposes and tax returns.
Calculation Of Accumulated Depreciation
We have understood the concept of accumulated depreciation very well. Accumulated depreciation is the sum of all depreciation over the useful life of a tangible asset. Let’s discuss some most commonly used methods of depreciation.
Straight Line Method
The most commonly used depreciation method across different business organizations is the straight-line method. The straight-line method divides the cost of the asset into equal parts over the useful life. Equal depreciation expense is realized in every accounting period.
Let’s see how to calculate the straight-line method.
The formula is
Depreciation = (Cost – Residual) / Years of Useful Life
Let’s do this by an example.
The cost of machinery is $18000. According to the company’s estimates, the residual value will be $3000. The estimated useful life of machinery is 5 years.
The annual depreciation expense will be calculated as:
Depreciation expense= (18000 – 3000) / 5
Depreciation expense= $3,000
The depreciation schedule under this method will look like this
|Year||Computation||Depreciation Expense||Accumulated Depreciation||Book Value|
|1||16000 * 1/5||$3,200||$3,200||$14,800|
|2||16000 * 1/5||$3,200||$6,400||$11,600|
|3||16000 * 1/5||$3,200||$9,600||$8,400|
|4||16000 * 1/5||$3,200||$12,800||$5,200|
|5||16000 * 1/5||$3,200||$16,000||$2,000|
The important thing to note is that an asset’s residual value is not accounted for by depreciation. The reason is that residual value is the amount a company expects to recover at the disposal of the discarded asset.
Many businesses used accelerated methods instead of straight-line methods for depreciation calculation. In the accelerated method, the early years of an asset’s life are charged high, and smaller accounts are written off later.
The most common practice under the accelerated depreciation method is the declining balance method.
Declining Balance Method
The declining balance method or fixed-percentage-of-declining-balance depreciation method is the most widely used accelerated depreciation method. This method is not common for financial reporting. However, it is more commonly adopted for tax purposes.
An accelerated depreciation rate is calculated at a fixed percentage of the straight-line depreciation rate in the declining balance method.
The accelerated depreciation rate is applied to the remaining book value of the asset for annual depreciation expense.
Depreciation Expense = Remaining Book Value X Accelerated Depreciation Rate
The accelerated depreciation rate is the ‘specific percentage’ of the straight-line rate. In most cases, it is 200% of the straight-line rate. Hence, it is called a double-declining balance.
Let’s understand this using the same example of $18000 worth of machinery with $2000 residual value and 5 years of useful life.
The straight-line rate was 20%(1 divided by 5). For the accelerated rate, we will take 200% of 20%. It will become 40% that is an exact double of 20%.
The depreciation schedule for machinery is given below.
|Year||Computation||Depreciation Expense||Accumulated Depreciation||Book Value|
|1||18000 * 40%||$7200||$7200||$10800|
|3||6480 * 40%||$2592||$14112||$3888|
In some cases, the 150 Percent declining method is also used. It takes 150% of the straight-line depreciation rate. For the above example, the 150% of 20% will be 30%, and the depreciation schedule will be made by the declining method.
Every year, the accumulated depreciation balance is credited against the depreciation. However, there are instances when the accumulated depreciation balance is debited. Suppose an asset of a company is retired or sold out. In that case, the accumulated depreciation balance is reversed and debited to offset the asset from the company’s books of accounts.