Accelerated Depreciation

Accelerated depreciation is a method of depreciation that refers to any of several methods through which a company depreciates a fixed asset for ‘financial accounting’ or tax purposes in such a way that the amount of depreciation taken each year is higher during the earlier years of the life of an asset. Accelerated depreciation methods, like double-declining balance (DDB), means there’ll be higher depreciation expenses within the first few years and lower expenses because of the asset ages. Therefore, under accelerated depreciation, an asset faces greater deductions in its value within the earlier years than within the later years.

Accelerated depreciation is also used as a technique for tax reductions. This is a valuable tax incentive that encourages enterprises to buy new assets. Companies or entities may use accelerated depreciation for tax purposes as these strategies result in tax liability deferment because earnings are lower in earlier periods. For financial reporting purposes, the two most well-liked methods of accelerated depreciation are the double-declining balance method and therefore the sum-of-the-years’ digits method. For tax purposes, the allowable methods of accelerated depreciation depend upon the jurisprudence that the taxpayer is subject to.

Accelerated methods of depreciation aim to match the known rate of depreciation of an asset with its actual usage although this is not theoretically essential. This alignment appears to occur because when it’s fresh, usable, and most effective, an asset is used the most. Under both financial accounting and tax accounting, companies aren’t allowed to assert the complete cost of a capital asset (any asset which might be used for several years) as an expense immediately. They have to amortize the asset costs for a specified period of time, usually an estimate of the asset’s useful life. It is not used as heavily as an asset age, as it is being phased out slowly for newer assets.

From the perspective of financial analysis, rapid depreciation appears to skew a business’ published results to show earnings which are lower than would usually be the case. In the long run, this is not the case as long as a company continues to accumulate and dispose of assets at a steady pace. To properly review a business that uses accelerated depreciation, it’s better to review its cash flows, as revealed thereon statement of money flows.

The most popular accelerated depreciation methods are the double-declining balance method and the sum of the years’ digits method. The formula for calculating depreciation using each of these methods is given below:

Double declining balance method:

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

A method of accelerated depreciation is the Double-Declining Balance (DDB) process. After taking the equivalent of the asset’s useful life and doubling it, this amount is added to the depreciable base also known as the book value, for the rest of the expected life of the asset.

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 the sum of the years’ digit

n = number of years

The sum-of-the-years’-digits (SYD) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset.

The only good thing about an accelerated method is that the timing of the deductions. Rapid methods have more tax savings within the early years and fewer savings in later years. Since managers of companies take the note value of cash into consideration, it’s better to own the savings early, instead of later. Governments typically provide tax deferment opportunities where there are clear policy reasons to promote an industry. For instance, in some countries accelerated depreciation is used to promote investment in renewable energy. In addition, governments have increased the accelerated methods of depreciation in times of economic stress (in particular, the US government passed laws after 9–11 to further accelerate depreciation on capital assets).

Accelerated depreciation requires additional estimates of depreciation and record-keeping, so for that reason, some businesses avoid it (although fixed asset software can easily overcome this problem). It can also be overlooked by businesses if they do not regularly gain a taxable income which takes away the primary justification for using it. Companies can also ignore accelerated depreciation if they need a comparatively bit of fixed assets since the tax effect of using accelerated depreciation is minimal.

Finally, if a company is owned publicly, management will be more interested in disclosing the maximum possible amount of net income in order to raise the stock price for the benefit of investors these companies would certainly not be involved in accelerated depreciation, which decreases the amount of net income reported.

 

Information Sources:

  1. accountingtools.com
  2. investopedia.com
  3. corporatefinanceinstitute.com
  4. wikipedia