Depreciation expense pertains to any depreciation incurred during the present period and thus belongs on the Income Statement. Here’s an example from Target Stores, which combined depreciation expense and amortization expense into a single line item.
Accumulated depreciation includes not just depreciation incurred during the present period, but depreciation from prior periods. Accumulated depreciation appears on the Balance Sheet and is a contra-asset account; it is subtracted from property, plant, and equipment to obtain property, plant, and equipment, net. Note that Target Stores had $18.181 billion in accumulated depreciation as of February 3, 2018, whereas it incurred about $2 billion in depreciation expense for the year ended February 3, 2018.
| Target Income Statements (in millions) | 2017 | 2016 | 2015 |
|---|---|---|---|
| Sales | $71,879 | $69,495 | $73,785 |
| Cost of sales | 51,125 | 49,145 | 52,241 |
| Gross Margin | 20,754 | 20,350 | 21,544 |
| Selling, general, and administrative expenses | 14,248 | 13,356 | 14,665 |
| Depreciation and amortization | 2,194 | 2,025 | 1,969 |
| Gain on sale | – | – | (620) |
| Earnings from continuing operations before interest and taxes | 4,312 | 4,969 | 5,530 |
| Net interest expense | 666 | 1,004 | 607 |
| Provision for income taxes | 718 | 1,296 | 1,602 |
| Net earnings from continuing operations | 2,928 | 2,669 | 3,321 |
| Discontinued operations, net of tax | 6 | 68 | 42 |
| Net Income | $2,934 | $2,737 | $3,363 |
| Target’s Assets (in millions) | Feb 3, 2018 | Jan 28, 2017 |
|---|---|---|
| Current Assets: | ||
| Cash and cash equivalents | $ 2,643 | $ 2,512 |
| Inventory | 8,657 | 8,309 |
| Other current assets | 1,264 | 1,169 |
| Total current assets | 12,564 | 11,990 |
| Property and equipment: | ||
| Land | 6,095 | 6,106 |
| Buildings and improvements | 28,396 | 27,611 |
| Fixtures and equipment | 5,623 | 5,503 |
| Computer hardware and software | 2,645 | 2,651 |
| Construction-in-progress | 440 | 200 |
| Accumulated depreciation | (18,181) | (17,413) |
| Property and Equipment, net | 25,018 | 24,658 |
| Other noncurrent assets | 1,417 | 783 |
| Total assets | $ 38,999 | $ 37,431 |
| Year |
Depreciation Expense |
Accumulated Depreciation |
|---|---|---|
| 1 | $ 8,000 | $ 8,000 |
| 2 | $ 8,000 | $ 16,000 |
| 3 | $ 8,000 | $ 24,000 |
| 4 | $ 8,000 | $ 32,000 |
| 5 | $ 8,000 | $ 40,000 |
Let’s say you start a pizza restaurant and purchase a pizza oven for $40,000. The oven (classified as property, plant, and equipment) is expected to have a useful life of 5 years and be worthless at the end of year 10. If you record deprecation on a straight-line basis (which is what Target Stores did), then you would recognize $8,000 of depreciation expense each year. The amount of accumulated depreciation, however, would change each year.
The accumulated depreciation at the end of year 4, for example, includes not just the $8,000 of depreciation taken during year 4 but the $24,000 of depreciation taken in years 1 through 3.
Why not simply reduce the asset account directly?
It might have occurred to you that we could simply reduce the amount of the pizza oven on the Balance Sheet instead of setting up the accumulated depreciation account. After year 2, for example, our Balance Sheet could simply say: Pizza Oven $24,000
instead of saying:
| Pizza oven | $ 40,000 |
| Accumulated depreciation | (16,000) |
| Pizza oven, net | $ 24,000 |
Reducing the asset’s book value directly is referred to as the direct writedown method, and it was used by some firms in the early 20th century.1 Companies eventually began keeping track of accumulated depreciation “on grounds of convenience” so investors could see how much wear and tear had occurred on the firm’s property, plant, and equipment.2 Whether the benefit of tracking this additional information exceeds the cost hasn’t been extensively studied, but one academic study suggests that investors do pay attention to accumulated depreciation.3
Reconciling Target’s depreciation expense to its accumulated depreciation
If you are a hardcover lover of accounting, you might be wondering why Target’s depreciation expense for fiscal year 2017 is not equal to the change in accumulated depreciation from FY 2016 to FY 2017.
This is for three reasons:
-
Target presented depreciation and amortization as a single line item
-
Target included depreciation costs in Cost of Sales
-
Target disposed of some of its property, plant, and equipment during the year
Target reported that depreciation and amortization expense was $2.445 billion after including depreciation from Cost of Sales. To find that amount of depreciation expense excluding amortization, we need to subtract $16 million of lease-related amortization expenses.
Thus, Target must have disposed of property, plant, and equipment with $1.661 billion of accumulated depreciation associated with it during fiscal year 2017.
Isn’t depreciation fun?
References:
- Simon, S. I. (1959). The right side of accumulated depreciation. The Accounting Review, 34(1), 97-105.
- Airey, C. R. (1959). Depreciation: Left or right? The Accounting Review, 34(4) 570-571.
- Kang, S., & Zhao, Y. (2010). Information content and value relevance of depreciation: A cross-industry analysis. The Accounting Review, 85(1), 227-260.
