What is Accelerated Depreciation?
Definition: Accelerated depreciation is defined as a depreciation method in which a company depreciates a fixed asset in such a manner that the amount of depreciation occurring in a year is higher during the earlier years of the life of an asset.
Accelerated depreciation is one of the methods used by the company to depreciate the value of the fixed account for tax purposes. Many companies often use this method as a tax reduction strategy. The double-declining balance method and the sum of the year’s digit method are two of the popular accelerated depreciation methods.
Depreciation, in general, means allocating the cost of a fixed asset over its productive life. Hence with each progressing year, the monetary value of an asset decreases over time. For financial reporting, the companies depreciate the value of the fixed assets through the accelerated depreciation method.
Importance of Accelerated Depreciation
The traditional method of depreciation involves spreading the cost evenly over the life of an asset. But In the accelerated depreciation method, the depreciated amount of a fixed asset will be higher in the first few years compared to the later period.
This method ensures the reduction in taxable income in the early years so that the tax liabilities are adjourned into the later period. A company can then enjoy the benefit of increased taxable income in the later years. This type of tax incentive encourages companies to procure new assets.
The rationality behind the accelerated depreciation is that when an asset is newly acquired, it is heavily used because it is more efficient. And as the asset becomes older, the efficiency is reduced. Hence, the depreciated amount of the asset in the initial years is higher.
Accelerated Depreciation Methods
There are many ways to calculate the accelerated depreciation value of the company. Two of the frequently used methods are the double-declining balance method and the sum of the years’ digit method.
1. Double Declining Method
Under the double-declining method, the depreciated amount is charged on the reduced value of an asset. The depreciated rate charged is twice the rate charged under the straight-line method. Hence this method over deprecates the value of an asset.
Double declining balance = 2 x straight-line depreciation rate x book value at the beginning of the financial year
2. Sum of the year digit method
Another way to calculate the accelerated depreciation is by using the sum of the year digits method. In this method, the asset’s expected life is added together with the digits for each year.
Under this method, the depreciation rate for each year is calculated by dividing the number of years remaining in assets life by the sum of remaining asset life every year through the asset’s life. Hence with the decrease in the depreciated rate in the preceding years, the depreciation charge also decreases.
Depreciation = depreciation cost x (no of years remaining in assets life/ sum of years digit)
Depreciation cost = cost of asset -salvage value
Sum of years digit = n (n+1/2); n = useful life of an asset
However, if the company does not use the accelerated depreciation method, then they use the standard method of depreciation that is the straight-line method.
Benefits of Accelerated Depreciation
Following are the benefits of the acceleration depreciation:
- Due to the nature of acceleration depreciation, the depreciation is accelerated that indicated higher expense in the earlier years as compared to later.
- As the company shows higher depreciation, this will help to reduce its current tax bills.
- This method results in the adjournment of tax liabilities due to the lower income in the early years.
- The money that was exempted from the tax amount can be re-invested for the growth of the business.
How can Accelerated Depreciation Adversely Affect a Company?
Following are the downside of the acceleration depreciation:
- Due to the nature of the acceleration depreciation, the deduction on depreciation in the later years is less. This could cause a problem for those companies who are in the growing phase. Since the method is not creating a large tax deduction, the company has to pay a higher tax rate.
- It is said that this method could cause complications in decision-making. It is because the over-depreciated value is charged on the asset.
- The major drawback which this method poses is the risk of recaptured depreciation. Since the depreciation rate is charged by this method is higher, the asset will lose its value over its predetermined time. According to the depreciation schedule, if that asset is sold before it is considered obsolete, then the profit a company will earn would be recaptured depreciation. And this would be taxed as an income. Also, the IRS will take back the deduction because the asset was not able to lose its value as expected.
The Straight-line Method of Depreciation vs Accelerated Depreciation
The straight-line method is the traditional method of depreciation. Unlike the accelerated depreciation, the depreciation value under this method is charged evenly over the course of the life of an asset.
Under this method of an asset is calculated by dividing the difference between an asset’s cost and its expected book value by the number of life-span of the assets. In accelerated depreciation, the value is charged double the rate of straight-line depreciation.
Relation between Accelerated Depreciation and Net Present Value
Rapid depreciation method like accelerated depreciation gives more scope to reduce taxes in the early year. Therefore the company can save a lot of amount in the early years.
And considering the concept of the time value of money, it is better to have excess savings in the prior year of the business. The company can later use it for re-investment. All this results in the improvement of the net present value of the business due to more cash inflow.
In the course of running a business, the company always looks for an opportunity for tax benefits. Accelerated depreciation is preferred by companies who want to defer tax payments.
However, due to its nature of depreciating, a lot of complications could arise in terms of adjustment. The reason being the company has to double the depreciating value of an asset.
Now, after going through the whole post, it is your turn to share your definition of accelerated depreciation in the comment section below.