What is Accumulated Depreciation: Meaning, Examples and Benefits
Accumulated depreciation is cumulative or total depreciation that an asset undergoes since it was put in operation. This depreciation is recorded in a contra asset account, meaning negative assets account. It reduces the gross amount of the underlying fixed asset, so it can neither be deemed as an asset nor a liability.
Read on to know the detailed meaning of accumulated depreciation that is explained with an example.
How Accumulated Depreciation Works?
Accumulated depreciation occurs due to the depreciation of an asset's value. Every financial year the depreciation expense that a company record gets added to the opening balance of accumulated depreciation. This enables companies to show asset costs as well as total depreciation value.
According to accounting principles, when a company purchases an asset, it does not consider it an expense. The company records that asset's total value on its balance sheet. However, once that asset is put into operation, it incurs depreciation every year. This depreciation gets recorded in the profit and loss account of the company.
This accumulated depreciation in the profit and loss account acts as a non-cash expense which reduces the total tax liability. While making a journal or ledger entry, companies debit all individual depreciation expenses and credit the accumulated depreciation account. As accumulated depreciation is a contra account, therefore crediting any entry will increase its value.
Example of Accumulated Depreciation
Suppose ABC Corporation purchases an asset on 1st January 2019. The cost of the asset machinery was ₹ 10,00,000, and its operational life cycle is 15 years. The residual value of the machinery was calculated at ₹ 1,00,000. It is the estimated value of a fixed asset at the end of its life cycle.
The procedure for calculating accumulated depreciation is given below:
Cost of Machinery (A)
Residual Value of the Machinery (B)
Applicable Depreciation Value (A-B)
So, the depreciation value per year was ₹ 9,00,000/15 = ₹ 60,000.
Now, we can calculate the accumulated depreciation by using this formula:
Accumulated Depreciation = Depreciation Value Per Year X Number of Years
So, the accumulated depreciation of the asset from 1st January 2019 to 31st December 2021 will be:
Accumulated Depreciation = 60,000 X 3 = ₹ 1,80,000
What is the Importance of Accumulated Depreciation?
Here are some benefits of accumulated depreciation:
Actual Value of Assets
The accumulated depreciation helps every company to get the real value of their assets. As an asset undergoes normal wear and tear, recording regular depreciation expenses in a company's books will provide the existing real worth of that asset.
However, if the company did not record any depreciation and records the asset's worth as unchanged from its purchase value, this will give a false value of the asset.
A company records depreciation in the profit and loss account as a non-cash expense. It reduces the revenue of the company and thereby reduces their tax liability as well. When an organisation does not record a depreciation expense, tax liability increases leading to companies paying more taxes.
A company can recover the total cost of investment on an asset by using the depreciation expense. The depreciation helps in recovering the cost of the asset over its entire lifetime. Companies can accurately analyse whether the asset requires repair or replacement by keeping track of depreciation expenses.
Moreover, companies can keep a part of revenue separately for the replacement of these assets. It ensures proper planning of future needs.
Productivity of Asset
Whenever a company records accumulated depreciation, it allows managers to get an accurate picture of expenses incurred while using that asset. They can then compare the expense with revenues generated by the respective asset. Therefore, it helps them in monitoring the productivity of assets.
By using accumulated depreciation, a company identifies the real value of an asset. The value of an asset on the balance sheet is the difference between its accumulated depreciation and the cost of purchase. At the end of an asset's useful life, the value on the balance sheet must equal salvage value.