We have addressed depreciation in a number of our accounting tutorials, for example our article covering depreciation on non-current assets; however we wanted to look specifically at the accumulated depreciation account and in particular address the question – is it a permanent account in the general ledger?
However, if you would like a fuller explanation … please read on.
What is Accumulated Depreciation?
Borrowing from our article on depreciation of fixed assets, depreciation is an expense to reflect the consumption of economic benefits a reporting entity can derive from an asset. Depreciation is not the matching of revenue and expenses, the revaluation of an asset or spreading the cost over a useful economic life. These are very much definitions of the past and don’t reflect the focus of accounting conceptual frameworks on assets and liabilities.
So that means accumulated depreciation is just that, an account that holds the normally growing balance of depreciation that a particular asset is building over a period of time. Or another way, it reflects the consumption of economic benefits the entity is enjoying from its control of that asset. Remember in accounting we are much more interested in the control over assets rather than their pure legal ownership.
Before we forget, accumulated depreciation is sometimes called provision for depreciation. We have tended to move away from using the word provision here because this is now covered by International Accounting Standard (IAS) 37 Provisions, Contingent Liabilities and Contingent Assets. We have a whole article on this in our accounting tutorial section and you can find that here.
Contra Accounts and Accumulated Depreciation
We mentioned contra accounts before and wanted to cover this quickly. All a contra account is is an account that maintains an opposite natural balance compared to the primary account it is being off-set against. This enables the primary account to maintain historical or core transaction data, while the contra account is used to effect the net balance of the primary account.
Technically accumulated depreciation could be run through the asset account. However, it is cleaner to record the depreciation entries in a dedicated account rather than off-setting the balance directly in the asset account.
In accounting we tend not to perform off-setting adjustments in accounts themselves. But rather use another permanent account, like accumulated depreciation, to do this instead.
Accumulated Depreciation Journal Entries and Disclosures
The final section in this article is to look at some journal entries and see how the accumulated depreciation is disclosed on the balance sheet (or statement of financial position).
Let’s assume that ABC Ltd is a brand new company on January 1. ABC has no expenses or revenues, however has $20,000 in the company bank account and equity (what the owner contributed) of $20,000.
On January 1 the company also buys a second hand truck for $12,000, paying cash. It would make the following entry:
The debit brings to account the second hand truck purchased, being a fixed asset for the company. And the credit decreases the bank account by $12,000.
The truck has an estimated useful life of five years with a residual value of $2,000. Using the straight line method of depreciation we now know that ABC will be depreciating the truck at $2,000 per annum for five years. The formula being:
$12,000 (purchase price) – $2,000 (residual value) = $10,000 (expected economic benefits)
$10,000 / 5 years = $2,000 depreciation per annum
It’s now the end of the financial year, being March 31. ABC has to prepare a set of financial statements. The following simple transactions took place in its first three months of operation:
- revenues of $20,000 ($15,000 in cash, $5,000 on account);
- truck operating costs of $5,000 (all cash); and
- wages of $9,000 ($7,000 cash, $2,000 owning).
For completeness lets prepare a journal for the above transactions and a separate one for the depreciation on the truck. This is of course all very simplified, but it just makes the example easier to go through.
|March 31||Truck Operating Expenses||5,000|
You wouldn’t normally prepare a journal like this, but in our simple case this isn’t a problem. The journal entries help to explain the financial statement account balances.
Now the depreciation journal entry would involve the following calculation and entry:
January 1 to March 31 = 3 months
3 months / 12 months = 25%
25% x $2,000 (depreciation expense for a year) = $500
|March 31||Depreciation Expense||500|
The debit raises the depreciation expense for the three months. While the credit increases the accumulated depreciation contract asset account from $0 to $500.
How these few simple transactions would look in the financial statements are set out below. In particular is the balance sheet and how we deduct the accumulated depreciation for the truck from its cost price. This then produces the net book value of the asset. In more complex accounts this calculation would not be presented on the face of the statement but rather as part of the asset notes.
And then in each subsequent year the same depreciation journal entry would be made, but for the full amount. So let’s look at the accounts for 31 March X2. We are going to use a simple general journal entry for the year’s activities of revenue and expenditure. But there is no truck purchase in year X2.
|March 31||Truck Operating Expenses||20,000|
|March 31||Depreciation Expense||2,000|
What we haven’t shown in the above is the assumption that the trade receivables and wage liability from the year X1 had been received and paid respectively. With those assumptions and the above journal entries the X2 year financial accounts for ABC Ltd would look like the following.
The main point for the X2 year accounts is to show you the depreciation expense of $2,000 in the statement of financial performance and the accumulated depreciation of $2,500 in the statement of financial position. You can see the contra account has the first year of $500 and the second year of $2,000 for depreciation added together. And thus reducing the net book value of the truck from $11,500 in X1 to $9,500 in X2.
We trust this article helps in your understanding of the accumulated depreciation account and why it is a permanent account in the general ledger of most accrual accounting systems.