Accelerated depreciation

What Is Accelerated Depreciation?

Accelerated depreciation is any method of depreciation used for accounting or income tax purposes that allows greater depreciation expenses in the early years of the life of an asset. Accelerated depreciation methods, such as double-declining balance (DDB), means there will be higher depreciation expenses in the first few years and lower expenses as the asset ages. This is unlike the straight-line depreciation method, which spreads the cost evenly over the life of an asset.

Accelerated depreciation is a method used to calculate asset value over time. It’s based on the principle that an asset’s value is highest at the beginning of its lifespan, allowing for more significant depreciation in value during these first few years.

Accelerated depreciation is the depreciation of fixed assets at a faster rate early in their useful lives. This type of depreciation reduces the amount of taxable income early in the life of an asset, so that tax liabilities are deferred into later periods. Later on, when most of the depreciation will have already been recognized, the effect reverses, so there will be less depreciation available to shelter taxable income. The result is that a company pays more income taxes in later years. Thus, the net effect of accelerated depreciation is the deferral of income taxes to later time periods.

A secondary reason for using accelerated depreciation is that it may actually reflect the usage pattern of the underlying assets, where they experience heavier usage early in their useful lives.

Background

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).

How does Accelerated Depreciation Work?

Depreciation of any kind is a reduction in the value of an asset that is placed in service for business purposes. The wear, tear, and usage of that asset will lower its value over time, and for accounting purposes, this is an expense to the business owner.

If you calculate the reduction in the value of an asset by dividing its value by its useful life (in years), this is called straight-line depreciation. This method assumes that the asset will lose value evenly over its lifespan.

For example, with straight-line depreciation, if you pay $20,000 for a truck and you expect it to have value for 10 years, your depreciation expense is $2,000 per year.

Accelerated depreciation assumes that the value of an asset will lower more quickly in the first few years in service (due to high use). It was also created as a way for business owners to lower taxable income while investing in a business by purchasing assets.

Special Considerations

Using an accelerated depreciation method has financial reporting implications. Because depreciation is accelerated, expenses are higher in earlier periods compared to later periods. Companies may utilize this strategy for taxation purposes, as an accelerated depreciation method will result in a deferment of tax liabilities since income is lower in earlier periods.

Alternatively, public companies tend to shy away from accelerated depreciation methods, as net income is reduced in the short-term.

Depreciation Methods

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.

1. Double declining balance method:

Double declining balance = 2 x Straight-line depreciation rate x Book value at the beginning of the year

2. Sum of the years’ digits method:

Applicable percentage (%) = Number of years of estimated life remaining at the beginning of the year / SYD

Where:

SYD = n(n+1) / 2

  • SYD stands for sum of the years’ digit
  • n = number of years

When Not to Use Accelerated Depreciation

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.

Financial Analysis Effects of Accelerated Depreciation

From a financial analysis perspective, accelerated depreciation tends to skew the reported results of a business to reveal profits that are lower than would normally be the case. This is not the situation over the long-term, as long as a business continues to acquire and dispose of assets at a steady rate. To properly review a business that uses accelerated depreciation, it is better to review its cash flows, as revealed on it statement of cash flows.

Tax Savings and Net Present Value

Companies often use rapid depreciation methods to reduce taxes in the early years of an asset’s life. It’s important to note that total tax deductions over the life of an asset will be the same no matter what method is used.  The only benefit of an accelerated method is the timing of the deductions.

Rapid methods offer more tax savings in the early years and fewer savings in later years. Since managers of businesses take the Time Value of Money into consideration, it’s better to have the savings early rather than later. It helps to improve the Net Present Value of the business.

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