Accelerated depreciation definition
/What is Accelerated Depreciation?
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.
Types of 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. The two main methods of accelerated depreciation are described below.
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Double Declining Balance Depreciation Method
To calculate depreciation under the double declining method, multiply the asset book value at the beginning of the fiscal year by a multiple of the straight-line rate of depreciation. The double declining balance formula is:
Double-declining balance (ceases when the book value = the estimated salvage value)
2 × Straight-line depreciation rate × Book value at the beginning of the year
A variation on this method is the 150% declining balance method, which substitutes 1.5 for the 2.0 figure used in the calculation. The 150% method does not result in as rapid a rate of depreciation at the double declining method, and so is used less frequently.
Sum of the Years’ Digits Depreciation Method
The sum of the years’ digits method derives a depreciation rate from the expected life of an asset. To use it, sum up the digits for each year. For an asset with a useful life of four years, the calculation would be 4+3+2+1 = 10. Then divide this total into each digit to arrive at the percentage that should be depreciated in each year. To continue with the example, this would be 40% depreciation in the first year, 30% depreciation in the second year, 20% depreciation in the third year, and 10% depreciation in the fourth and final year.
Advantages of Accelerated Depreciation
There are several advantages associated with the use of accelerated depreciation, which are as follows:
Deferred income taxes. Accelerated depreciation results in more depreciation expense being recognized earlier, which reduces the amount of taxable income reported in the near term. This means that accelerated depreciation results in some income taxes being deferred to later time periods.
Improved cash flow. A natural consequence of income tax payments being deferred to later periods through the use of higher depreciation deductions is an improvement in your cash flow. This larger amount of cash can be invested in financial assets to generate a return, or it may be reinvested in the business to enhance its competitiveness.
Might reflect asset usage patterns. Accelerated depreciation may actually reflect the usage pattern of the underlying assets, where they experience heavier usage early in their useful lives. When this is the case, the assets in question are more likely to be replaced at an earlier date.
Disadvantages of 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, publicly-held companies tend not to use accelerated depreciation, on the grounds that it reduces the amount of their reported income. When investors see a lower reported income figure, they tend to bid the price of a company’s stock downward. This is not the case for privately-held companies, which are under no pressure to report favorable net income figures to anyone. Consequently, privately-held companies are more likely to use accelerated depreciation than publicly-held ones.
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 its statement of cash flows.
Accelerated Depreciation vs. Straight-Line Depreciation
There are several differences between accelerated and straight-line depreciation. First, the amount of depreciation that can be taken in the first few years is much higher with an accelerated depreciation method, while (as the name implies) straight-line depreciation allows for a consistent amount to be depreciated in each period. Second, accelerated depreciation is more complicated to calculate than straight-line depreciation. And finally, accelerated depreciation is less likely to reflect the actual usage pattern of the underlying assets, while straight-line depreciation provides a better representation of usage.
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