Financial-market participants pay close attention to fixed-asset expenses that department heads unveil in corporate budgets, because these blueprints often provide insight into long-term growth strategies. Accumulated depreciation entries indicate the amounts of tangible resources that a firm relies on to generate revenues. These entries draw on cost accounting procedures and long-term financial-reporting policies and techniques.
To understand the concept of "accumulated depreciation," it's helpful to be familiar with the depreciation mechanism. Depreciation enables a firm to allocate over several years charges that are related to a fixed asset. Also known as a tangible or long-term resource, a fixed asset usually serves in a company's operations for more than one year. Accountants call "useful life" this operating time frame. Tangible resources include equipment, machinery, land and factory plants. Accumulated depreciation is the sum of all depreciation expenses recorded on a fixed asset since the asset's purchase.
The accumulated depreciation account has a credit balance. It is a contra-account, meaning it reduces the value of an asset account. To record depreciation expense, a corporate accountant debits the depreciation expense account and credits the accumulated depreciation account. As a contra-account, accumulated depreciation lowers an asset’s value over time, bringing this value to zero at the end of the resource’s useful life.
Accumulated depreciation entries affect two financial statements: a statement of financial position and a statement of profit and loss, also called an income statement. Depreciation expense is an income statement component, whereas accountants report accumulated depreciation on the statement of financial position.
The Internal Revenue Service allows companies and individuals to depreciate equipment used for business purposes. Under IRS guidelines, taxpayers may allocate fixed-asset costs using an accelerated depreciation method or straight-line depreciation method. An accelerated depreciation method allows a taxpayer to spread allocate higher asset costs in earlier years. In a straight-line depreciation procedure, allocation costs are the same every year.
A company’s top leadership is concerned that the latest round of operating adjustments isn’t bearing fruit. Senior executives want to purchase additional equipment to boost production levels and prevent a steep drop in operating income. The company purchases new manufacturing equipment and machinery valued at $1 million. The corporate controller believes a 10-year straight-line depreciation schedule is appropriate, given the equipment’s useful life. At the end of the year, a corporate accounting manager debits the depreciation expense account for $100,000, or $1 million divided by 10, and credits the accumulated depreciation account for the same amount. The new equipment’s value decreases to $900,000, or $1 million minus $100,000. Using a similar approach, the equipment’s book value is zero at the end of the tenth year. Accumulated depreciation at that time equals $1 million.