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For example, purchasing a company car for $40,000 and selling it for $10,000 five years down the lane leads to a total loss of $30,000 in asset value. Similar is the case for most machinery and other business equipment such as computers, copiers, and furniture. Businesses, however, rarely absorb all this loss in one go, and rather make provision in their balance sheet every year to set off a portion of such anticipated losses, even though there is no actual cash outgo.
Accumulated depreciation is a contra account. Businesses place the amount set of for depreciation into this account and add back this amount to the net income in the cash flow statement.
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The purpose of the company setting aside accumulated depreciation is to reduce the carrying value of assets to reflect the loss of value due to wear, tear, and usage, and thereby, provide an accurate position of the worth of company’s assets to the stakeholders.
If the company did not cater to the accumulated depreciation, the asset would should an inflated value out of sync with reality. In the example of the car quoted above, at the end of year five if accumulated depreciation was not used, the car would still show a value of $40,000 on the company’s balance sheet, which is far removed from reality. Providing annual depreciation makes the value of the asset more in accord with reality.
Another reason why companies cater to accumulated depreciation is to prevent huge “shocks" in the profit and loss statements. Absorbing a big loss in one owing to the sale of an obsolete capital asset can lead to the balance sheet showing a loss, when the company would have made operational profits. This distorts the reality, and spreading over the loss across the year, in portion to the usage of the asset, allows the balance sheet to reflect the actual cost of utilizing the asset in the same accounting year.
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Recording Accumulated Depreciation
Recording accumulated depreciation takes place in the contra account every year. Overtime, when the company effects a sale of a business asset, the business sets off the actual loss incurred on the sale from the contra account, and removes the similar amount from the balance sheet and the contra amount. Any additional loss reflects as losses for the accounting year, and any gains as profits for the accounting year.
To illustrate, in the example of the car purchased for $40,000 quoted above, if the company has set off accumulated depreciation of $30,000 for the car over the years, and the car sells for $15,000 instead of $10,000, the sale price is $5,000 more than the accumulated depreciation of $30,000. The balance sheet then lists this $5,000 as profit. Similarly, if the sale of the car fetches only $8,000, the total loss from the sale of this asset is $32,000 and the additional $2,000 over the $30,000 set off in the accumulated depreciation contra account ($1000-$8000) is recorded as loss on the balance sheet.
Such methods provide ample scope for manipulating the balance sheet and can greatly distort the profit and loss of the company. The scope for distortions become even more as individual balance sheets rarely show accumulated depreciation, and rather list only a single line entry "Property, Plant, and Equipment - net" The accumulated depreciation charges usually find mention in the annual report or 10K statement.
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Kieso, Donald E; Weygandt, Jerry J.; and Warfield, Terry D.: Intermediate Accounting, Chapter 11. ISBN 978-0-471-44896-9.
Image Credit: flickr.com/Brandie