Accelerated Depreciation

What is Accelerated Depreciation?

The term "accelerated depreciation" indicates the methods in which the asset cost depreciates more quickly than the straight-line approach, which uniformly distributes the expense over the asset's useful life. This method is used for accounting and/or income tax purposes, and the basic assumption behind this approach is that assets produce more value or are more effective in their initial years than they do later on. As a result, it causes depreciation expenses to be higher in the early years of an asset's life than they are in the later years.

Though it's not actually necessary, accelerated depreciation methods typically align the recognized rate of an asset's depreciation with its actual use since an asset is used more frequently when it is new, fully operational, and most effective. An accelerated form of depreciation makes sense as it usually happens at the start of an asset's lifespan and is in line with the way the underlying asset is utilized. As asset ages, it is less frequently employed since it is being phased out in favor of newer assets.

Types of Accelerated Depreciation Method

The Declining Balance Method of Depreciation and the Sum of year Digit Method of depreciation are the two most popular methods of depreciation. A detailed explanation is given below:

Declining Balance Method of Depreciation

With the declining balance approach, an asset's book value is depreciated at a fixed rate each year, resulting in accelerated depreciation (higher depreciation values in the initial years of the asset's useful life). The most popular depreciation rate is a double-declining depreciation approach, which is about 2X times the straight-line method.

The formula for calculating depreciation is:

Example

Consider a $10,000 asset with a five-year useful life, after which its residual value is zero.

The formula of the Straight-line depreciation method is:

Suppose we use the accelerated depreciation approach with a factor of 2X, or 40% per year. Then,

The depreciation amount for the First Year = 10,000 * 40% = 4,000

The depreciation amount for the Second Year = 6,000 * 40% = 2,400

The depreciation amount for the Third Year = 3,400 * 40% = 1,360

The depreciation amount for the Fourth Year = 2,040 * 40% = 816

In this way, it will have zero residual value in the final year of depreciation.

Therefore, we see that when using the accelerated depreciation approach, the asset is highly depreciated in the initial years and then gradually decreases in subsequent years. Although this form of accelerated depreciation has some financial regulatory implications, it typically benefits the company.

Sum-of-Years Digit Method

It is another popular type of accelerated depreciation, and the formula for calculating depreciation is as follows:

Example

Let's take the $10,000 asset as an example, which has a 5-year useful life and no salvage value.

Sum of the useful Years of the Asset = 5+4+3+2+1 = 15

The following shows the depreciation factors:

First Year = 5/15

Second Year = 4/15

Third Year = 3/15

Fourth Year = 2/15

Fifth Year = 1/15

For each year, the amount of depreciation will be:

The depreciation amount for the First Year = 10000 * 5/15 = 3333.3

The depreciation amount for the Second Year = 10000 * 4/15 = 2666.7

The depreciation amount for the Third Year = 10000 * 3/15 = 2000

The depreciation amount for the Fourth Year = 10000 * 2/15 = 1333.3

The depreciation amount for the Fifth Year = 10000 * 1/15 = 666.7

Again as above, it is seen that the earliest years are where the majority of depreciation costs are incurred.

Advantages

Reduction in Start-Up Business Deductions

The earliest years of depreciation are charged at a greater rate under the approach of accelerated depreciation, allowing for reporting of higher initial expenses. Since depreciation is a non-cash expense, money does not leave the company when this accounting method is applied, resulting in higher costs and lower net income on paper. Therefore, companies can use this capital for their primary business operations because they initially have to pay fewer taxes.

Higher Upfront Deduction

The ability for businesses to deduct more in the initial years is another major benefit of the accelerated depreciation approach. When a company is new and is experiencing temporary cash flow issues, it will directly assist by saving its current year's taxes.

Tax Deferral Mechanism

The notable and one of the main reasons why corporations employ accelerated depreciation approaches in their accounting is tax deferral. If this method is employed, they will be able to postpone paying a portion of the tax to future years as it will make a provision for deferred tax liability (DTL) in the account books. Organizations can use this to their benefit by postponing the tax and paying it later when they anticipate future years will be more profitable. They can easily pay and reduce this DTL to zero at some moment.

Disadvantages

Preferential Treatment

This approach enables the company to write off expenses more quickly than an asset wears out, which can lead to biases in decision-making over when and how much to invest.

Recaptured Depreciation Risk

With this approach, the asset may be sold once total depreciation is documented on paper. However, since it hasn't entirely broken down, the asset still has some usable life and is still economically valuable. As the asset wasn't completely depreciated in such cases, the income tax department will take back the deductions, turning the situation into a losing one.

Future Deduction is a Problem for Growing Business

Only initial years can have higher deductions under the accelerated method. However, it does not actually result in a sizable tax deduction, and this amount that is deferred can be a big issue for firms that are expanding as, over time, their revenue will rise, and they will enter a higher tax bracket and be required to pay more.

When is Accelerated Depreciation avoided?

Because it necessitates more depreciation computations and record keeping, some businesses avoid accelerated depreciation. However, there are many software available to overcome this issue. It may also be disregarded by businesses if they aren't constantly earning taxable income, eliminating its main benefit. If a company just has a modest number of fixed assets, implementing accelerated depreciation may not be worth it because it has a negligible tax impact.

Lastly, accelerated depreciation is typically avoided by publicly traded corporations because it lowers their reported earnings. Investors often push down the price of a firm's share when they view a decreased reported income figure. Privately owned businesses are not required to disclose favorable net income numbers to anyone; thus, this isn't the case with them. As a result, privately held businesses tend to employ accelerated depreciation more frequently than publicly traded firms.

Impact of Accelerated Depreciation

In comparison to other sectors, it has a greater impact on the manufacturing industry. In addition to impacting the company's income statement, It also influences the company's other financial measures, such as the debt-to-asset ratio, profit margin ratio, return-on-asset ratio, etc. The utilization of accelerated depreciation has an impact on the company's tax strategy as well. In the same way that it was previously explained, it lowers the enterprise's current tax liability while increasing it in the long term. As a result, the business must devote a lot of time to arranging its taxes for the present year while also considering those for the years to come.

Effects of Accelerated Depreciation on Financial Analysis

Accelerated depreciation has the tendency to inflate a company's reported results, revealing lesser earnings than would typically be the case from the viewpoint of financial analysis. As long as a corporation keeps buying and selling assets at a regular rate, this won't be the case in the long run. Reviewing a company's cash flows, as shown on its cash flow statement, is preferable to correctly evaluate one that employs accelerated depreciation.

Accelerated Depreciation vs. Straight-Line Depreciation

Accelerated and straight-line depreciation differ in various ways. A straight-line approach, as the name suggests, provides for a constant amount to be depreciated for each year, but an accelerated approach allows for a significantly larger amount to be depreciated in the initial years. Secondly, the calculation of accelerated depreciation is more difficult than that of a straight line. Last but not least, straight-line depreciation represents utilization better than accelerated depreciation since it is more likely to accurately reflect the real usage pattern of the underlying assets.