If you purchased a new car for $50,000 and resold it three years later for $30,000, you would have experienced a $20,000 loss on the value of your asset. As you just learned in the last section, a business would write a portion of this loss of value off each year, even though it required no cash outlay, reducing reported profits.
The accounting entry has to be put somewhere on the financial statements. It is kept in a special type of account (known as a contra account) on the balance sheet known as accumulated depreciation. Frankly, you don't need to worry about that. You just need to know that your balance sheet is going to look like this:
Car Asset - $50,000 value
Accumulated Depreciation - Car - ($20,000 value)
Net Asset Value - Car: $30,000
As you can see, the purpose of the accumulated depreciation account is to reduce the carrying value of an assets to reflect the loss of value due to wear, tear, and usage. Companies purchase assets such as computers, copy machines, buildings, and furniture, all of which lose value each day. This depreciation loss must be accounted for in the company's financial statements in order to give shareholders the most accurate portrayal of the economic realty of the business.
If you have trouble understanding the concept of accumulated depreciation, think about the problem this way: If a company bought $100,000 worth of computers in 1989 and never recorded any depreciation expense, the balance sheet would still show an asset worth $100,000. Do you really think that computers that old, which wouldn't even run today's software, are worth anywhere near that amount? At most, you'd be lucky to get a few hundred dollars for scrap parts.
Accumulated Depreciation - Net
When you look at a balance sheet, you aren't going to see the individual assets and many businesses don't even bother to show you the accumulated depreciation account at all. Instead, they show a single line called "Property, Plant, and Equipment - net" it is referring to the fact that the company has deducted accumulated depreciation from the purchase price of the company's assets. To see the amount of those depreciation charges, you will probably have to delve into the annual report or 10K.
Once the asset has become worthless or is sold, both it and the matching accumulated depreciation account are removed from the balance sheet. Any gain or loss above the book value, or carrying value, is recorded according to specific accounting rules depending on the situation. If, for instance, the car we discussed above sold for $27,000 despite having a carrying value of $30,000, a business would record a $3,000 loss, adjusted for the income tax savings that would result.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.