One of the most important things when running a small business is keeping accurate accounting records. They help you gauge your profitability, get funding from investors, and stay out of trouble with the Internal Revenue Service (IRS).
In the United States, we use the accrual method of accounting. This means that revenue and expenses are recognized on accounting documents when they're earned or incurred. With the accrual method, fixed or tangible assets are depreciable over time.
This guide aims to explain accumulated depreciation. We'll go over what accumulated depreciation is, a few methods for depreciating your company's fixed assets, and how to record accumulated depreciation on your accounting documents.
What is Accumulated Depreciation?
For a fixed asset, accumulated depreciation is the total depreciation amount of the cost of the asset that has already been accounted for. Depreciation means recognizing the expense of a fixed asset over time. Fixed assets are the physical property that a company uses to bring in revenue.
Examples of fixed assets are things like factory machinery and computer software. Fixed assets are noncurrent (long-term) investments, meaning they will create earnings for more than a year.
When your company purchases a fixed asset, it will decide the number of years that the asset can be used for (the asset's useful life) and how much the item can be sold for at the end of that time (the salvage value). On the business's accounting documents, the purchase price of the asset is split over its useful life until it reaches its salvage value.
For example, if you're a freelance programmer, you might purchase a computer to create software. The asset costs $2,000. You decide that the computer will be obsolete in five years (the useful life). After that, you can sell it for $200 (the salvage value). You would recognize the $2,000 depreciation expense of the computer over five years until it has been depreciated to $200.
A journal entry for monthly depreciation is different from a normal account. In a normal asset account, a debit increases the value of the account while a credit decreases the value of the account. An accumulated depreciation account is a contra-asset account. A credit increases its value, while a debit decreases it.
Companies also depreciate intangible (non-physical) assets like copyrights and trademarks. The process for depreciating these assets is called amortization.
How do you calculate Accumulated Depreciation?
The two most common ways to calculate accumulated depreciation are the straight-line method and the declining-balance method. Over the next few sections, we'll go over how to determine depreciation using either method and provide real-world examples for using each one.
This is the most straightforward way to depreciate an asset. Every year, you recognize an equal part of the total amount you paid for the item. At the end of the asset's life span, it will be depreciated to its salvage value. Below is the equation for using this depreciation method:
|Depreciation for One Year
For instance, your construction business purchases a backhoe for $35,000 (total price). You decide your business will use the item for five years (life span). After that, the asset can be sold for $5,000 (salvage value).
Your straight-line depreciation rate would be 20% per year. Each year, you would recognize $6,000 of your backhoe's cost. The asset would be depreciated to $5,000 at the end of its useful life (after five years).
This method is a little trickier than the straight-line method because the amount you'll be depreciating changes (declines) each year. The idea behind declining-balance depreciation is that your business can recognize a larger portion of an asset's cost early on and less over time.
You might use the declining-balance method of depreciation when your company purchases an asset that has a greater decline in value early in the item's life span (like a car or a computer). It allows your business to reap tax benefits for the item earlier. Two typical forms of this method you can use are double-declining balance depreciation and 150% declining balance depreciation.
Double-Declining Balance Method
Using the double-declining balance method, you'll depreciate double the straight-line depreciation percentage of the asset the first year. After that, you'll depreciate the same percentage of the item's book value (the current value of an asset after depreciation) every year until it reaches its salvage value.
Remember that the net book value of the asset and its annual depreciation will decrease each year as the item is depreciated. You can use the below equation.
|Depreciation for One Year
|(Straight Line Depreciation Percentage x 2)
Let's say you've purchased a company truck for your plumbing business. The vehicle's initial cost is $24,000. The useful life of the vehicle is 10 years, and the salvage value is $4,000. Under the straight-line method, you would depreciate the truck by $2,000 (10%) each year.
Using the double-declining method, you'll depreciate the item by $4,800 (20% x $24,000) the first year. The next year, the book value of the asset will be $19,200 ($24,000 - $4,800), and you'll depreciate it by $3,840 (20% x $19,200). Repeat this process until you reach the $4,000 salvage value.
150% Declining Balance Method
Using the 150% declining balance method, you'll multiply your straight-line depreciation rate by 1.5 (150%) instead of 2. For our above example, you would depreciate your company truck by 15% each year. Below is an equation to help you understand this method.
|Depreciation for One Year
|(Straight Line Depreciation Percentage x 1.5)
The first year, you'll depreciate the item by $3,600 (15% x $24,000). The second year, the book value will be $20,400 ($24,000 - $3,600), and you'll depreciate the asset by $3,060 ($20,400 - $3,060).
How is Accumulated Depreciation recorded on a balance sheet?
Accumulated depreciation will show up on your company's balance sheet under fixed assets on the left side (assets) of a balance sheet. The amount of accumulated depreciation will be in parentheses to show that it reduces the value of the assets.
A common way that fixed, or long-term, assets will show up on a balance sheet is property, plant, and equipment (PP&E). Here's an example of a cross-section of your balance sheet:
|Building and Renovations
|Less: Accumulated Depreciation
|Cost Less Depreciation
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According to generally accepted accounting principles (GAAP), all publicly traded companies in the U.S. must use the accrual method of accounting. When you're using the accrual method, you must depreciate fixed assets over time.
While keeping track of your company's accumulated depreciation can get complicated in some situations, doing so is essential if you want to remain in compliance with federal laws. It can also help you, as well as investors, understand the value of your business at a given time.
Things like doing your own bookkeeping, writing income statements, and managing your own income tax can drain the fun out of owning a startup. Skynova has accounting software that can make processes like bidding and invoicing way easier. Take a look at our free business templates and software products to see how they can optimize your accounting processes.
Notice to the reader
This article is a basic guide to accumulated depreciation. It might not be applicable to your specific business needs. It's important to seek the advice of an accounting expert or certified public accountant (CPA) before making any large financial decisions for your company.