What is Accumulated Depreciation?

Accumulated depreciation is reported on the balance sheet as a long-term asset. Asset depreciation expense is reported on the income statement as a deduction. Companies will report depreciation expense in continuing operations as an other expense item.

Book vs Tax Accumulated Depreciation

Taxing authorities have a variety of provisions that allow businesses to increase their annual depreciation expense to lower taxable income. This creates differences between book and tax accumulated depreciation accounts.

Let’s say that your balance sheet has $700,000 in fixed assets. You depreciate these assets using the straight line depreciation method. Your balance sheet currently has $400,000 in accumulated depreciation. However, for tax purposes, you immediately expensed these assets using accelerated depreciation options, resulting in an accumulated depreciation account balance of $650,000.

The difference in the value of your fixed assets needs to be carefully tracked to report accurate gains and losses when assets are sold and record proper annual depreciation expense.

How to Calculate Accumulated Depreciation

Since accumulated depreciation is the culmination of current and prior depreciation expense, the first step is to calculate your depreciation expense. The depreciation formula varies based on the method used. For simplicity, we will use straight line, which calculates depreciation evenly over an asset’s useful life.

Let’s say you place three assets in service during the current year: a machine for $15,000, a computer for $5,000, and a new desk for $3,000. According to the IRS, machinery and office furniture have an estimated useful life of seven years, while a computer’s useful life is five years. Assuming no salvage value and that all assets will be depreciated for 12 months, we have the following calculations:

• Machine – $15,000 / 7 years = $2,143
• Computer – $5,000 / 5 years = $1,000
• Desk – $3,000 / 7 years = $429

In our depreciation expense account, we will report $3,572 for the accounting period, which can be recorded on a monthly basis or annually with a depreciation journal entry. This asset depreciation will also be added to the carrying value of our accumulated depreciation account.

The Importance of Tracking Accumulated Depreciation

Annual accumulated depreciation is important to track. Not only does it help you maintain compliance with regulatory agencies, but it also gives you insights into your asset value and overall company financial health. Here are some other reasons why accumulated depreciation in an important contra asset account:

Compliance with Regulators

Taxing authorities have specific rules on how companies can depreciate a capital asset. By monitoring your accumulated depreciation account, you can ensure that you aren’t over-depreciating assets. In addition, your company can report accurate depreciation recapture when you do sell depreciated assets.

Informed Business Decisions

Accurate depreciation schedules help your business know when to replace assets and how much you might need to budget. For example, if you notice one of your machines is nearing its useful life, you might want to start the search for a new one. Not only can you continue generating qualifying depreciation deductions, but you can also eliminate any disruptions from a down machine.

Maximize Tax Savings

Depreciation expense is a non-cash deduction. This means you can lower taxable income without actually paying any expenses, not including the initial asset purchase. By watching your depreciation accounts, you can determine which assets might be eligible for accelerated depreciation to further lower your taxable income.

Evaluate Company Health

Since accumulated depreciation reduces your net asset account value, it gives you important insights into reinvestment activities. If you notice your net fixed asset account is rapidly declining, it can indicate it’s time to reinvest in new equipment. This can help you grow your business and show investors that you are committed to the financial health of your company.

Summary

• Accumulated depreciation is a contra account to fixed assets, reporting current and past depreciation expenses.
• There’s a difference between book and tax accumulated depreciation, making it important to track both to report accurate tax returns and depreciation expense.
• Tracking accumulated depreciation improves compliance with regulatory agencies, gives you information to make informed business decisions, maximizes tax savings, and allows you to evaluate your company’s health.