Knowing how to calculate accumulated depreciation is an integral part of financial accounting. Businesses record every activity through financial statements to ensure smooth progress and keep track of their assets, liabilities, and investments. These financial statements are used to evaluate and illustrate the financial health of a business, its progression, and any impediments that may require correcting.
Calculating accumulated depreciation is essential to making informed decisions about the future. The information obtained from it helps businesses reflect the precise value of the assets under their ownership. It presents a gradual reduction in the value of an asset over its useful life until the asset’s value reaches zero.
The information provided by accumulated depreciation is notably interesting and helpful for investors who may be contemplating making a loan to the business or investing in it. If they see an asset close to being fully depreciated, they will know that the company will soon have added expenses because of being obliged to purchase a new asset.
It also showcases a company’s gains and losses when it either stops operating an asset or sells it. Additionally, Depreciation does not involve any cash. It is done for tax purposes–like determining the taxable gain on the sale.
After reading this article, you will have a profound understanding of accumulated depreciation and all the various ways of calculating it.
Accumulated depreciation is the total worth of depreciation expense that a fixed asset has experienced since it was acquired and put into use. It is a contra asset account, meaning it is a negative assets account.
Accumulated Depreciation = Depreciation Expense x Years after purchase
While fixed assets are intended for longer use, their value is not infinite. Fixed assets slowly decrease in value over time due to wear and tear, usage, obsolescence of technology, or passage of time. This process is most often recorded through the methods of depreciation- when an expense of an asset is spread over a period of time in which it will be useable. Accumulated depreciation is just the sum of all depreciation expenses that a fixed asset has incurred since purchase.
What will the Journal Entries look like?
Here are the steps for creating journal entries for depreciation expense and accumulated depreciation:
Step 1: Make a journal entry for the purchase of a fixed asset.
|Fixed asset – equipment||$ 1000|
If we purchase a fixed asset – for example, some type of equipment- for $1000, the journal entries made upon the purchase will be as follows: The asset with the name of equipment will be debited (+) and Cash will be credited (-) with the amount of 1000 dollar.
Step 2: Calculate Depreciation expense
To calculate accumulated depreciation (sum of depreciation expenses) we first need to calculate depreciation expense. There are four main methods for calculating it: Straight-line method, Double declining balance method, sum-of-the-years’ digits, and units of production method.
The first two are the more widely used methods, which is why we will be discussing them in detail further on. More information about the latter two methods can be found here.
Step 3: Make journal entries for Depreciation expense and Accumulated depreciation.
After doing the annual calculations depreciation expense will be debited in the income statement, while the same amount will be credited to the accumulated depreciation account in the balance sheet (since it is a contra-asset account credit will increase the amount). As time passes accumulated depreciation will slowly increase until it is equal to the original cost of the asset when it was purchased or until the asset is disposed of.
|Depreciation expense||$ 1500|
|Accumulated depreciation||$ 1500|
Since accumulated depreciation is a contra-asset account it reduces the book value of an asset. A book value is determined by subtracting accumulated depreciation from the fixed asset. The net book value will decrease until its salvage value is reached.
When the asset is disposed of or sold, the accumulated depreciation account is debited (contra-account: debit decreases) and the fixed asset will be credited by the same amount, after which the asset will be removed from the balance sheet.
|Accumulated depreciation||$ 2000|
|Fixed asset (x)||$ 2000|
The most common method of depreciation, where the costs of an asset are spread evenly over its useful life.
Depreciation expense = (Purchase cost – Salvage value) / Estimated Useful Life
- Salvage value- an estimated resale value of a fixed asset expected at the end of its life. The worth of an asset once it is retired.
- Useful life- The estimated lifespan of a product; a time period you expect the asset will be useful for. The IRS has a website that provides estimates of most assets’ lifespans.
“Dream Spoon” company bought an ice-cream truck for $20,000 on January 1, 2019. They believe that the useful life of the truck is 6 years and that at that time it can be sold for $2,000. What is the balance of accumulated depreciation on 31st December 2021?
Annual Depreciation Expense =
= $ 3,000
This means depreciation expense debited will be $ 3,000 every year. Since, three years have passed since the purchase of the truck, accumulated depreciation at the end of 2017 will be:
Annual Depreciation (2017) = 3000 x 3 = $ 9,000
Double- Declining balance method
Another method for calculating depreciation is by using the declining balance method. It depreciates the value of an asset at an accelerated rate; thus, depreciation is going to be expensed higher during the early years of its use rather than at the end. There are several declining methods, however, double declining is the most commonly used one.
Depreciation Expense = 2 x Depreciation rate x Book Value
- Depreciation rate = 1/useful life of an asset.
- Book value = Purchase cost of an asset – accumulated depreciation to this day.
“Dreamcatcher” Ltd. Bought new equipment for their production for $30,000. They expect the equipment to last for five years and to have a salvage value of $3,000 upon retirement. If the equipment was bought on January 1st, 2016, what would be the accumulated depreciation on December 31st, 2018? Use the double declining balance method to calculate.
Determine the depreciation rate. Since the estimated useful life of the machine is 5 years, the depreciation rate will be 1/5, meaning 20%.
Determine the book value of the machine.
Book Value = Purchase cost – accumulated depreciation
This means that the book value will change every year. Since in 2016 accumulated depreciation is zero:
Book Value 2016 = Purchase cost = $30,000
Calculate the Depreciation expense for year 1, year 2, and year 3.
Depreciation Expense (2016) = 2 x 0.2 x 30,000 = $12,000
The book value will continue changing, thus, depreciation expense will need to be calculated annually unlike the straight-line method in which it remains the same amount every year.
Depreciation Expense (2017) = 2 x 0.2 x (30,000-12,000) = $ 7200
Depreciation Expense (2018) = 2 x 0.2 x (30,000-19,200) = $ 4320
Calculate Accumulated Depreciation. Accumulated Depreciation = sum of depreciation expenses:
|Depreciation Expense (2016)||$ 12000|
|Depreciation Expense (2017)||$ 7200|
|Depreciation Expense (2018)||$ 4320|
|Accumulated Depreciation (2018)||$ 23 520|
Based on the same situation, we can calculate the depreciation expense for all five years. The results will be as follows:
net book value ($)
|Depreciation expense ($)||Accumulated depreciation ($)||Ending net book value ($)|
As you can see, the depreciation expense in year 5 is only $888. Now, if you calculated it based on the formula we have used thus far, it would be equal to $1555.2 (3888*0.4). However, the total accumulated depreciation using the double declining balance method cannot be higher than the original cost – salvage value (30,000-27,000). This is due to the fact that when you reach your salvage value, you sell the asset and that is when the depreciation stops.
Sum of the years’ digits method
This method also calculates depreciation at an accelerated rate. It does so by using the sum of an asset’s useful life:
Depreciation Expense =
(Purchase cost – Salvage value) x Years left in an asset’s life/sum of asset’s useful life
A bonus of this method is that it takes into consideration the fact that an asset’s performance/ usefulness will decline over time.
XYZ company purchased a car for $6,000. They believe the car will be useful for 4 years and that they can sell it for $1000 after the time is up. Calculate the accumulated depreciation after four years using the sum-of-the-years’ digits method.
- Depreciable amount = purchase cost- salvage value = 6000-1000= $ 5,000
- Sum of the useful life = 1 + 2 + 3 + 4 = 10
- Calculate depreciation factor. Depreciation factor = (Remaining life/ SOY)
|1||4/10 = 0.4|
|2||3/10 = 0.3|
|3||2/10 = 0.2|
|4||1/10 = 0.1|
4. Calculate the depreciation expense for every year.
|Year||Depreciation factor||Calculation||Depreciation expense|
|1||0.4||5000 x 0.4||2000|
|2||0.3||5000 x 0.3||1500|
|3||0.2||5000 x 0.2||1000|
|4||0.1||5000 x 0.1||500|
5. Calculate accumulated depreciation after four years. Accumulated depreciation = sum of depreciation expense = 2000 + 1500 + 1000 + 500 = $5000.
Units of production method
This method is very situation specific, as it calculates depreciation based on the number of units produced per year and is thus useful in manufacturing environments. It is largely used by companies whose production varies greatly every year based on the market situation and demand. The calculations for this method involve two main steps:
Step 1: Calculate Depreciation per unit.
Depreciation per unit = (Purchase cost – Salvage value)/ Estimated units produced during an asset’s useful life
Step 2: Calculate depreciation expense.
Depreciation Expense (annual) = Depreciation per unit x units produced in the year
Additional Notes and Tips on the topic
- Generally, depreciation expenses are recorded annually, however, for bookkeeping purposes they can also be recorded either monthly or quarterly.
- It is important to know what the date of purchase for an asset is and how the company defines its fiscal year-end. Generally, most companies stick with December 31st, however, this is company specific and needs to be checked.
- The depreciation method used can vary based on a business. They should be appropriate for the asset in question. In order to achieve this the matching principle is used. Knowing which method is being used for accounting is important as one cannot arbitrarily change between methods.
- Accumulated depreciation helps a business decide where to invest. It also helps them determine capital gains/losses on an asset when it is sold or retired.