What it means
When a company buys a machine for $100,000 that will last ten years, it records the machine at cost and then charges depreciation of $10,000 a year to the income statement. Rather than reducing the cost figure directly, accounting keeps the original cost intact and builds up the total depreciation charged in a separate account.
After three years the balance sheet shows the machine at cost $100,000 less accumulated depreciation $30,000, giving a net book value of $70,000. Keeping cost and accumulated depreciation separate preserves information.
A reader can see what the company paid for its assets, how much of that cost has been used up, and therefore roughly how old the asset base is. A company whose accumulated depreciation is 80% of the cost of its equipment is running old assets and will soon need to spend on replacements.
One whose accumulated depreciation is 20% of cost has invested recently. That ratio is a common early check on whether a business has been underinvesting.
Accumulated depreciation grows each period by the depreciation charge and is reduced only when an asset is sold, scrapped or written off, at which point both the cost and the accumulated depreciation of that asset are removed from the books. The difference between the sale proceeds and the net book value is the gain or loss on disposal.
It is important not to confuse accumulated depreciation with a fund of cash set aside for replacement. It is an accounting record of cost consumed, not money.
A company with $5 million of accumulated depreciation may have nothing in the bank. Nor does net book value represent market value: a fully depreciated truck may still run for years and be worth a good price, while a lightly depreciated computer may be obsolete.
In practice
Real-world examples.
Example
A factory's balance sheet shows plant and machinery at cost $12 million less accumulated depreciation $9 million; an analyst notes that the equipment is largely worn out on paper and asks about the capital expenditure plan.
Example
A company writes off a fully depreciated computer system that is still in use; cost and accumulated depreciation of $80,000 each are removed with no effect on profit.
Example
A landlord's building shows cost $2 million and accumulated depreciation $500,000, but a recent valuation puts the building at $3.5 million; the accounts stay at net book value unless the company adopts a revaluation policy.
Think of it
“Accumulated depreciation is like tracking the total miles on a car's odometer. Each year adds more miles, and the total tells you how much life has been used up.
Formula
Calculation
Accumulated Depreciation = Sum of all depreciation charges to date
Net Book Value = Original Cost minus Accumulated Depreciation
Straight-line annual depreciation = (Cost minus Residual Value) / Useful Life
Worked example. A delivery company buys a van for $48,000 with an expected useful life of six years and a residual value of $6,000.
- Annual depreciation = ($48,000 minus $6,000) / 6 = $7,000
Balance sheet position at the end of each year:
- Year 1: cost $48,000, accumulated depreciation $7,000, net book value $41,000
- Year 2: accumulated depreciation $14,000, net book value $34,000
- Year 3: accumulated depreciation $21,000, net book value $27,000
- Year 4: accumulated depreciation $28,000, net book value $20,000
At the end of year 4 the company sells the van for $23,000.
- Gain on disposal = $23,000 minus $20,000 = $3,000
- Entries: remove cost of $48,000 and accumulated depreciation of $28,000 from the books, record cash of $23,000 and a gain of $3,000
Asset age check: across the whole fleet, cost is $600,000 and accumulated depreciation is $420,000, so 70% of the fleet's cost has been depreciated and the average vehicle is about 4.2 years into a 6-year life. Replacement spending is imminent.Case study
Seen in the real world.
A buyer was evaluating a printing business whose accounts showed fixed assets with a net book value of $400,000 and steady profits. Looking at the fixed asset register, the buyer's adviser found the original cost of the presses was $3.8 million and accumulated depreciation was $3.4 million: the equipment was almost fully depreciated and, on inspection, twelve to fifteen years old. The low depreciation charge in recent years had been flattering profit by around $300,000 a year compared with what a business running modern presses would report.
The buyer reduced the offer by $1.5 million, the estimated cost of replacing the two oldest presses within three years, and structured part of the price as deferred consideration contingent on the presses continuing to operate. The seller, who had thought of the presses as "paid for", had never considered that the buyer would see them as a liability in waiting.
Watch out
Common mistakes.
- Treating accumulated depreciation as cash saved for replacement. It is a record of cost consumed, not a fund.
- Assuming net book value equals market value. They are unrelated; one is an accounting allocation, the other a price.
- Leaving accumulated depreciation on the books after an asset is sold or scrapped, which overstates both cost and depreciation.
Questions
People also ask.
Is accumulated depreciation an asset or a liability?
Neither in the normal sense. It is a contra-asset, shown as a deduction from the related asset on the balance sheet.
Can accumulated depreciation exceed the asset's cost?
No. Depreciation stops when the asset reaches its residual value or is fully depreciated.
What happens to accumulated depreciation when an asset is revalued?
Under a revaluation model it is either eliminated against the cost or restated proportionately so that the net amount equals the new valuation.
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