Accelerated Depreciation Method

What is Accelerated Depreciation?

Definition: Accelerated depreciation is a method of allocating larger portions the cost of an asset in earlier years of the asset’s life and less in the later years of useful life. In other words, an accelerated depreciation method does exact what the name implies. It front-loads larger amounts of depreciation on the beginning years and smaller amounts in later years. This is opposed to the straight-line method that allocates an equal amount of depreciation every year throughout the asset’s useful life.

Accelerated depreciation is any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset. While the straight-line depreciation method spreads the cost evenly over the life of an asset, an accelerated depreciation method allows the deduction of higher expenses in the first years after purchase and lower expenses as the depreciated item ages.

What Does Accelerated Depreciation Mean?

What is the definition of accelerated depreciation? The rational behind an accelerated method is that assets are generally more useful when they are new. Thus, the costs should be allocated according to the actual asset usage instead of equally throughout the useful life. This makes sense since depreciation isn’t a way to “expense” an asset. It’s a method for allocating the asset’s cost of benefits.

There are several calculations available for accelerated depreciation, such as the double declining balance method and the sum of the years’ digits method. If a company elects not to use accelerated depreciation, it can instead use the straight-line method, where it depreciates an asset at the same standard rate throughout its useful life. All of the depreciation methods end up recognizing the same amount of depreciation, which is the cost of the fixed asset, less any expected salvage value. The only difference between the various methods is the speed with which depreciation is recognized.

Companies in many countries pay taxes on profits: revenues minus expenses. There are various types of expenses, including salaries paid to workers, cost of inputs, and amortization and depreciation. Profits for tax purposes will, in most countries, differ from accounting profits or earnings.

Under both financial accounting and tax accounting, companies are not allowed to claim the entire cost of a capital asset (any asset which can be used for many years) as an expense immediately. They must amortize the cost of the asset over some period, usually an approximation of the useful life of the asset. The depreciation basis is the cost incurred by the company in acquiring the asset. The useful life of the asset is determined by looking at Section 168(e)(3) of the United States Tax Code, and is known as the class life of the property. An example would be that a railroad track has a useful life of 7 years. This is not the end of the analysis however, because then it becomes necessary to look at the applicable recovery period of the property. The applicable recovery period determines the number of years over which the property should be depreciated. Section 168(e)(1) provides a table for determining the applicable recovery period. Following our 7 year railroad track, the table states that property with a useful life of more than 4 years but less than 10 years will be treated as 5 year property. Finally, it is important to determine the applicable convention for depreciation. Section 168(d)(4) of the U.S. Tax Code gives three different types: half year convention, the mid-month convention, and the midquarter convention. Conventions determine how much of the depreciation deduction the taxpayer may take the first year. This prevents taxpayers from claiming a full year’s deduction when the asset has only been in service for part of the year.

Governments generally provide opportunities to defer taxes where there are specific policy reasons to encourage an industry. For example, accelerated depreciation is used in some countries to encourage investment in renewable energy. Further, governments have increased accelerated depreciation methods in time of economic stress (in particular, the US government passed laws after 9-11 to further accelerate depreciation on capital assets).

Example

As a simple example, a company buys a generator that costs $1,000 that is expected to last for 10 years. Under the most simple form of depreciation, the company might allocate $100 of the cost of the generator to its expenses every year, until the $1000 capital expense has been “used up.” Under accelerated depreciation, the company may be allowed to allocate $200 of the cost of the generator for five years.

If the company has $200 in profits per year (before consideration of the cost of the generator or any effects of debt or other factors), and the tax rate is 20%:

  • Normal depreciation: the company claims $100 in depreciation every year and has a tax profit of $100; it must pay tax of $20 on the $100 gain. Over ten years, $200 in taxes are paid.
  • Accelerated depreciation: the company claims $200 in depreciation for the first five years, and nothing for the last five years. For the first five years, it has no taxable profit and pays no gains tax. For the last five years, the company has a gain of $200, and pays $40 per year in tax, for a total of $200.

To compare these two (simplified) cases, the company pays $200 in taxes in both instances. In the second case, it has deferred taxes to a much later period. The deferral of taxes to a later period is favorable according to the time value of money principle.

(This example has been simplified for a basic demonstration of how accelerated depreciation works. It does not factor in an accurate class life, recovery period or account for convention.)

Why it matters

When a company uses an accelerated depreciation method, it lowers the value of its total assets on its balance sheet earlier in the life of those assets. Many companies employ accelerated depreciation methods when they have assets that they expect to be more productive in their early years.

Accelerated depreciation helps companies shield income from taxes – after all, the higher the depreciation expense, the lower the net income. High depreciation expenses recorded now, however, mean less depreciation expenses recorded later – thus higher net income and taxes at the end of the asset’s useful life. Essentially, this means that accelerated depreciation defers taxes for companies rather than helps companies avoid taxes.

Companies with large tax burdens might favor accelerated depreciation methods more – even if using those methods results in lower net income – because the cash saved in taxes can be reinvested in the business or given to shareholders.

Investors should take the time to understand the assumptions and methods companies use to calculate depreciation.

When Accelerated Depreciation is Not Used

Accelerated depreciation requires additional depreciation calculations and record keeping, so some companies avoid it for that reason (though fixed asset software can readily overcome this issue). Companies may also ignore it if they are not consistently earning taxable income, which takes away the primary reason for using it. Companies may also ignore accelerated depreciation if they have a relatively small amount of fixed assets, since the tax effect of using accelerated depreciation is minimal. Finally, if a company is publicly held, management may be more interested in reporting the highest possible amount of net income in order to buoy its stock price for the benefit of investors – these companies will likely not be interested in accelerated depreciation, which reduces the reported amount of net income.

Special Considerations

Utilization of an accelerated depreciation method has financial reporting implications. Because depreciation is accelerated, expenses are higher in earlier periods compared to in later periods. Companies may utilize this strategy for taxation purposes, as an accelerated depreciation method will result in a deferment of tax liabilities due to income being lower in earlier periods. Alternatively, public companies tend to shy away from accelerated depreciation methods, as net income is reduced in the short-term.

Accelerated Depreciation Methods

The double declining balance (DDB) method is an accelerated depreciation method. After taking the reciprocal of the useful life of the asset and doubling it, this rate is applied to the depreciable base, book value, for the remainder of the asset’s expected life. For example, an asset with a useful life of five years would have a reciprocal value of 1/5 or 20%. Double the rate, or 40%, is applied to the asset’s current book value for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base each period.

The sum-of-the-year’s-digits (SYD) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset. For example, an asset with a five-year life would have a base of the sum of the digits one through five, or 1+ 2 + 3 + 4 + 5 = 15. In the first depreciation year, 5/15 of the depreciable base would be depreciated. In the second year, only 4/15 of the depreciable base would be depreciated. This continues until year five depreciates the remaining 1/15 of the base.

Summary Definition

Define Accelerated Depreciation: Accelerated depreciation means a method of assigning a higher percentage of an asset’s cost when the asset is newer and a lower percentage when the asset is older.

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