Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology
Assets such as equipment and vehicles lose value over time, but how do you show that on your accounting books? This lesson will demonstrate how to account for depreciation over the course of multiple years and calculate an asset's current value.
Accumulated Depreciation Defined
When a company buys a piece of equipment, like a forklift, for instance, the value of that machinery decreases as time passes and as it continues to be used by the machine's operators. Basically, that forklift loses value over time due to these things. From an accounting standpoint, the amount of decrease that's allowed by accepted accounting principles is tracked over time so managers will accurately know the value of the company's equipment.
Accumulated depreciation is a contra-asset account that's made for each asset that'll be depreciated by the end of the accounting period. Contra-asset accounts are those types of accounts that have a normal credit balance instead of a debit balance. Think of it as your personal credit card account versus your normal checking account. The accumulated depreciation account is the amount that the asset's original value needs to be decreased by to show the current value.
Let's assume for a minute that you have your own company. Let's also assume that your company has a machine that puts shrink-wrap on products before they are placed in boxes and sent off to wholesalers and retailers for sale. The cost of that machine when it was purchased was $10,000 and it's thought to have a useful life of around 10 years and no salvage value, meaning at the end of its useful life the machine will be worth $0. Using the straight-line depreciation method, we see that the equipment will be depreciated by $1,000 each year. The straight-line depreciation method basically will show this: $10,000 cost minus $0 salvage value divided by 10 years.
On the books, you'll have an asset account for your equipment. For simplicity, we will assume that this is your only equipment owned. When purchased, you would debit the equipment account for $10,000 and credit cash for the same amount.
Formula and Example
The formula for figuring out how much an asset will depreciate each year looks like this:
This might seem a little complicated, but don't worry! It's actually pretty simple. We'll use our shrink-wrap company example to understand it.
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Let's say that your company is growing and you need to upgrade your shrink-wrap machine. The new shrink-wrap machine will cost $50,000 to purchase. That's the cost of asset. You're expecting to get about 15 years of use out of this machine, which is the useful life of the asset. Finally, you think it'll be worth about $5,000 at the end of its useful life. With these numbers, we can calculate the annual depreciation expense: $50,000 - $5,000 = $45,000. $45,000 / 15 years = $3,000/year. This means, following the straight-line depreciation model, the new shrink-wrap machine will depreciate at a rate of $3,000 per year.
Now that we have our annual depreciation expense, we can calculate the net book value of the new machine at year-end. The formula for figuring out the book value of the depreciating asset looks like:
That's a little simpler isn't it? Now, let's say it's been six years and we want to know the book value of the shrink-wrap machine. All we have to do is multiply the annual depreciation expense ($3,000) by the amount of years since purchase (6 years) and subtract that number from the original purchase cost: $50,000 - ($3,000 * 6) = $50,000 - ($18,000) = $32,000. After six years, your upgraded shrink-wrap machine has a book value of $32,000. Another way of looking at this is that your machine has an accumulated depreciation of $18,000 after six years.
Accumulated depreciation is the total of each year's depreciation expense that is not closed out at the end of each accounting period. Remember that accumulated depreciation is a contra-asset account that has a normal credit balance to counter the amount of decrease in value from the asset's original purchase price. Each year the asset's depreciation is assessed using the appropriate method. That amount is debited to depreciation expense and credited to accumulated depreciation.
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