Is accumulated depreciation an expense? Every company or business make use of fixed assets such as plants, machinery, motor vehicle, building, etc., in carrying out production, it is important to charge depreciation on these assets over their years of useful life. The aggregate of this amount is the accumulated depreciation. In this article, we see what is accumulated depreciation, what is an expense, and whether accumulated depreciation is an expense.
What is accumulated depreciation?
Accumulated depreciation is the total amount of depreciation expense of a company’s assets. It symbolizes a decrease in an asset’s economic value over its years of useful life. In other words, accumulated depreciation is the cumulative depreciation of an asset up to a single point in its life. It is a contra-asset account which means that its natural balance is a credit that brings about a decrease in the overall value of an asset.
The matching principle of accounting under the generally accepted accounting principles states that expenses much be matched to the same accounting period in which the related revenue is generated. It is through depreciation that a business expenses a portion of a capital asset’s value over each year of its useful life. This means that each year, a company puts a capitalized asset to use and generates revenue, therefore, the cost associated with putting the asset to use is recorded.
So, in each accounting period, the depreciation expense recorded is added to the beginning accumulated depreciation balance. The carrying value of an asset on the balance sheet is equal to the difference between its historical cost and the accumulated depreciation. At the end of the useful life of an asset, its carrying value on the balance sheet will match its salvage value.
When recording depreciation in the general ledger, a company debits the depreciation expense and credits accumulated depreciation. Depreciation expense, in the period it is recorded, flows through to the income statement. The balance of accumulated depreciation increases over time, adding the amount of depreciation expense recorded in the current period.
Accumulated depreciation depends on the asset’s salvage value which is determined as the amount a company may expect to receive in exchange for selling an asset at the end of its useful life. In essence, depreciation spreads out the cost of an asset over the years, allocating how much of the asset has been used up in a year, until the asset is obsolete or no longer in use. If depreciation was not in place, a company would incur the entire cost of an asset in the year of its purchase. This, in turn, could have a negative impact on a company’s profitability.
The amount of accumulated depreciation for an asset will increase over time as depreciation expense is continually recorded. At the eventual sale of the asset or when it is put out of use, the accumulated depreciation associated with that asset will be reversed thereby eliminating all the asset records from the company’s balance sheet.
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What is an expense?
An expense is the amount of money spent and costs incurred by a company in pursuit of revenue. In other words, expenses are costs that are involved in running a business, which collectively contribute to the activities involved in profit generation. In essence, an expense is viewed as an outflow of cash and other valuable assets from a company to an individual or business.
We can also view expense as an event where liability is incurred or an asset is used up. By examining the accounting equation, it is obvious that expenses are used to reduce owners’ equity.
While expenses and costs seem to be identical, there is an important difference between the two terms when it comes to accounting. While costs are those financial resources put forward in order to purchase an asset, the use and consumption of these assets are termed expenses. For instance, purchasing a van by a company might be an example of a cost, then, the payment for fueling the vehicle as well as servicing are examples of expenses. With this, all expenses can be categorized as costs but not all costs are necessarily expenses.
Common examples of expenses are rent expenses, wages expenses, and utility expenses. Depreciation is also an expense as it decreases the value of an asset in an accounting period. However, it is important to note that depreciation expense is treated differently from accumulated depreciation.
All expenses are recorded or listed in a company’s income statement and here, the total revenue minus expenses will determine a company’s net profit. Expenses are increased by a debit entry and when they are recorded, a corresponding credit entry has to be recorded in either an asset or a liability account in accordance with the principle of double-entry bookkeeping.
Expenses can be recorded either on a cash basis or an accrual basis. Under cash basis accounting, a company records expenses only when it makes a cash payment to the supplier or employee. Under the accrual basis of accounting, on the other hand, a company records expenses when there is a reduction in the value of an asset regardless of whether there is any related cash outflow.
A company may record the purchase of an asset as an expense if the amount paid is less than the capitalization limit used. If the amount, on the other hand, is higher than the capitalization limit, the company would instead record it as an asset and then charge it to expense at a later date when the asset has been consumed.
Is accumulated depreciation an expense?
In order to understand whether accumulated depreciation is an expense or not, it is important to understand that depreciation comprises two forms, the depreciation expense, and the accumulated depreciation. So with this, we can say that accumulated depreciation is not an expense, depreciation expense is. Accumulated depreciation is a contra-asset account that connotes a cumulative reduction in the value of a fixed asset over its years of useful life. In other words, it is an asset account with a credit balance.
Depreciation, generally, is seen as a reduction in the economic value of an asset. The fact that in another context, an expense is defined as a reduction in the value of an asset as it is used in revenue generation, is one thing that brings about confusion with regard to whether accumulated depreciation is an expense. Also, expense takes the form of depreciation and is charged over the useful life of an asset, this is the depreciation expense.
We can also see that the International Accounting Standards define expenses as a decrease in economic benefits during the accounting period which takes the form of cash outflows or the depletion of assets. Because the phrase, “depletion of assets” is mentioned in the definition, there is a need to clarify the form of depreciation, in accounting terms, that is categorized as an expense.
Accumulated depreciation is considered a contra-asset account because it contains a negative balance that is intended to offset the asset account with which it is paired, which results in its net book value. In other words, accumulated depreciation appears on the balance sheet as a reduction from the gross amount of fixed assets reported. This shows that accumulated depreciation is not an expense.
When depreciation is an expense
Almost every business or company records depreciation on the income statement, which is listed as an expense. This is to be recorded whenever an item is calculated at year-end or the end of an accounting period. Depreciation is calculated for the purpose of tax or to determine the item’s validity for liquidation purposes. With this, the depreciation amount that appears on the income statement is categorized as an expense.
In essence, depreciation expense is recorded on the income statement just like any other normal business expense. Here, the asset is used in carrying out production, and in the process, it wears out. This expense is recorded on the income statement. The depreciation amount is listed as an expense because it reflects the portion of the acquisition cost of the asset for the purpose of production. For instance, factory machines that are used in the production of a good have attributable revenues and costs. So, to determine the attributable depreciation expense, the company estimates the asset’s years of useful life and scrap value.
In essence, depreciation is considered an expense when the portion of an asset has been considered consumed in the current period. So, that portion is charged and reduced from the cost of the asset. The essence of this charge is to gradually reduce the carrying amount of the asset as its value is consumed over time. Therefore, it is a non-cash expense which means that there is no related cash outflow.
When an accounting entry is made to the depreciation expense account, it also makes an offsetting credit entry to the accumulated depreciation account, which is a contra-asset account that offsets the assets account. Over the course of an entity’s fiscal year, there is an increase in the depreciation expense account. This amount is then flushed out or written off to zero as part of the year-end closing process. The account is then used again to keep a record of depreciation charges in the next accounting period.
Having said this, accumulated depreciation is recorded on the balance sheet while depreciation expense is recorded on the income statement. So, for accounting purposes, accumulated depreciation is not an expense.
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