Accelerated depreciation refers to any one of several methods by which a company, for ‘financial accounting’ or tax purposes, depreciates a fixed asset in such a way that the amount of depreciation taken each year is higher during the earlier years of an asset’s life. For financial accounting purposes, accelerated depreciation is expected to be much more productive during its early years, so that depreciation expense will more accurately represent how much of an asset’s usefulness is being used up each year. For tax purposes, accelerated depreciation provides a way of deferring corporate income taxes by reducing taxable income in current years, in exchange for increased taxable income in future years. This is a valuable tax incentive that encourages businesses to purchase new assets.
What is ‘Accelerated Depreciation’
Accelerated depreciation is any method of depreciation used for accounting or income tax purposes that allows greater deductions in the earlier years of the life of an asset. While the straight-line depreciation method spreads the cost evenly over the life of an asset, an accelerated depreciation method allows the deduction of higher expenses in the first years after purchase and lower expenses as the depreciated item ages.
Explaining ‘Accelerated Depreciation’
Accelerated depreciation methods are sometimes mostly logistical. Although an asset is not required to be depreciated in the same manner in which it is used, an accelerated depreciation method tends to make this occur. This is because an asset is most heavily used when it is new, functional and most efficient. Because this tends to occur at the beginning of the asset’s life, the rationale behind an accelerated method of depreciation is that it appropriately matches how the underlying asset is used. As an asset ages, it is not used as heavily, since it is slowly phased out for newer assets.
Financial Reporting Implications
Utilization of an accelerated depreciation method has financial reporting implications. Because depreciation is accelerated, expenses are higher in earlier periods compared to in later periods. Companies may utilize this strategy for taxation purposes, as an accelerated depreciation method will result in a deferment of taxation liabilities due to income being higher in later periods. Alternatively, public companies tend to shy away from accelerated depreciation methods, as net income is reduced in the short-term.
Example: Double Declining Balance Method
The double declining method is an accelerated depreciation method. After taking the reciprocal of the expected life of the asset and doubling it, this rate is applied to the depreciable base for the remainder of the asset’s expected life. For example, an asset with an expected life of five would have a reciprocal value of 1/5 or 20%. Double this rate, or 40%, is the constant rate applied to the asset for depreciation. Although the rate remains the same, the dollar value will decrease because the rate is applied to a smaller depreciable base each period.
Example: Sum-of-the-Year’s Digits Method
The sum-of-the-year’s-digits (SYD) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset. For example, an asset with a five -ear life would have a base of the sum of the digits one through five, or 15. In the first depreciation year, five-fifteenths of the depreciable base would be depreciated. In the second year, only four-fifteenths of the depreciable base would be depreciated. This continues until year five depreciates the remaining one-fifteenth of the base.
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