Accumulated depreciation on the balance sheet, and how it relates to depreciation expense is one of the most confusing concepts of accounting to beginners. To make it easier to understand, let’s start with the basics of how depreciation works.
When a company has assets like machinery, equipment, buildings, and vehicles, these items are usually expected to last longer than one year. But, they also decline in value over time, and so to account for the decline in value, depreciation is the method by which the declining value is measured. A quick example that anyone can understand is when a car is new, it might be worth $20,000. After 2 years, even if the car is still in perfect condition, it’s now only worth $16,000. In other words, the car’s value has depreciated by $4,000.
When it comes to accounting for depreciation, the first step is to record the depreciation expense. So with the example we just gave, let’s say that ABC company bought the car for $20,000 as a company vehicle. ABC company expected to be able to use the car for 10 years, and so for every year that passes, ABC will record $2,000 of depreciation expense. So after 2 years, $4,000 has been depreciated, leaving the book value of the car at $16,000 (20,000-4,000=$16,000). This $4,000 of depreciation that has accumulated, is called “accumulated depreciation”.
Accumulated Depreciation on the Balance Sheet
Accumulated depreciation is the other part of recording depreciation correctly. As equipment depreciates, depreciation expense is recorded. Accumulated depreciation is simply the running balance of depreciation that has accumulated against the value of the equipment. So accumulated depreciation on the balance sheet just reduces the book value of the equipment. Here’s what it would look like on the balance sheet:
Less: Accumulated Depreciation………………(4,000)
Another crucial thing to understand when it comes to depreciation is to realize how the accounts work together. Depreciation expense has a debit balance, since it’s an expense account. Accumulated depreciation is a contra-asset account, so it has a credit balance. So the way it works is that when depreciation expense is recorded, or debited, then the accumulated depreciation account is credited for the same amount. Here’s how it looks:
The accumulated depreciation account is used in accounting so that the recorded cost of the equipment can stay on the books, and the contra-asset account of accumulated depreciation is used so that the depreciation of the equipment can be kept track of year to year. One final note is that depreciation expense is a temporary account, which means that its balance is closed to the income summary at the end of every accounting period, which is usually at the end of the year.