What is Accelerated Depreciation?
Accelerated Depreciation is the accounting depreciation method in which asset cost is allocated in a faster manner than traditional methods and this will lead to larger expenses in the earlier years than the later period of asset’s useful life. The main purpose of using this method is the belief that assets are more productive in the early years than later years.
Top 2 Accelerated Depreciation methods
The most commonly used Accelerated Depreciation methods are the Declining Balance Method of Depreciation and Sum of year Digit Method of depreciation. Let us discuss each one of them in detail –
#1 – Declining Balance Method of Depreciation
Under this declining balance method, a constant rate of depreciation is applied to an asset’s book value each year which results in accelerated depreciation (higher depreciation values in the early years of the life of an asset). Most commonly used is the rate of depreciation is 2X of the straight-line method known as double declining depreciation method.
The basic formula to calculate Accelerated Depreciation using double declining method is
Declining Balance Method Example
An asset of worth $10,000 has a life of 5 years and its salvage value is 0 after 5 years.
So as per the straight line depreciation method:
- Depreciation at every year = (Book Value of an asset- Salvage Value)/life of an asset
- Dep every year = (10000-0)/5=$2000 per year or 20% per year.
Now if we are using accelerated depreciation method with a factor of 2X i.e. 40% per year
- the depreciation expense in first year = book value* rate of dep. = 10000*40%= $4000 in year1
- In year 2 depreciation = book value* rate of dep = 6000*40%= $2400 in year 2
- Depreciation in year 3 = 3400*40% = $1360 in year 3.
- Depreciation in year 4 = 2040*40% = $816
- In last year it will be fully depreciated with 0 residual value.
So we observe that in accelerated depreciation method we depreciate the asset heavily in the first few years and gradually it decreases in further years.
Though this accelerates depreciation method have certain financial regulatory implication but it gives advantages to the firm to use.
#2 – Sum of Year Digit Method
Sum of Year Digit Depreciation is an accelerated depreciation wherein the depreciation is calculated using the following formula
Sum of year depreciation = Number of useful years remaining/sum of useful years * (Depreciable amount)
Sum of Year Depreciation Example
Let us consider the asset $10,000 with a useful life of 5 years and no residual value.
Sum of useful life = 5 + 4 + 3 + 2 + 1 = 15
The depreciation factors are as follows
- Year 1 – 5/15
- Year 2 – 4/15
- Year 3 – 3/15
- Year 4 – 2/15
- Year 5 – 1/15
Depreciation Expense for each year will be
- Depreciation in year 1 = $10,000 x 5/15 = $3333.3
- Depreciation in year 2 = $10,000 x 4/15 = $2666.7
- Depreciation in year 3 = $10,000 x 3/15 = $2000
- Depreciation in year 4 = $10,000 x 2/15 = $1333.3
- Depreciation in year 5 = $10,000 x 1/15 = $666.7
We again note that most of the depreciation expense is charged in the initial years.
How Accelerated Depreciation Method lower the tax outgo?
Let’s take an example to demonstrate how using accelerated depreciation method results in lower tax outgo in initial years. Here we will prepare income statement for tax purposes.
Case #1 – Tax Income Statement with Straight Line Method of Depreciation
Here we assumed that the Asset is worth $1,000 with a useful life of 3 years and is depreciated using straight-line depreciation method – year 1 – $333, year 2 – $333 and year 3 as $334.
- We note that the Tax Expense is $350 for all the three years.
Case 2 # Tax Income Statement as per the Accelerated Depreciation Method
Let us now assume that for tax reporting purposes, the company uses an accelerated method of depreciation. The depreciation profile is like this – year 1 – $500, year 2 – $500 and year 3 – $0.
- We note that the Tax Payable for Year 1 is $300, Year 2 is $300 and Year 3 is $450.
Here we observe that the tax payment is lower in starting years if we use accelerated depreciation method instead of the straight line method and due to this we will have higher net income and higher cash in hand in the initial years.
also, have a look at what is deferred tax liability?
Advantages of Accelerated Depreciation Method
Given below are the advantages of the accelerated depreciation method
#1 – Reduction in start-up business deductions:
This method allows to report higher expenses in initial years as the depreciation cost is charged higher in beginning years if this method is used in accounting this leads to higher expense and which will bring down the net income on paper( on paper because depreciation is a non cash expense, funds do not actually flow out of organization). So by these firms has to pay lower taxes in initial years and they can utilize this fund in their core business activities.
#2 – Higher upfront deduction
Another huge advantage of accelerated depreciation method is that it will allow organizations to make higher deductions in starting years and this will save their current year tax that will directly help when your business is new and you have short-term cash flow problems.
#3 – Tax Deferral Mechanism
The biggest and one of the reasons corporates use accelerated depreciation methods in their accounting is the tax deferral i.e. if you are using this method then you will be able to defer a part of tax to future years as it will create a provision of deferred tax liability (DTL) in books of accounts and by this organization can take this as their advantage in deferring the tax and paying it later when they expect future years will be more profitable for them and that time easily they can pay and bring this DTL to 0.
Disadvantages of Accelerated Depreciation Method
Given below are the disadvantages of the accelerated depreciation method
#1 – Preferential Treatment
This method allows the business to deduct their expenses faster/quicker than the asset actually worn out and this will lead to decision biases like when to invest and how much to invest.
#2 – Future deduction a problem for growing business
The accelerated method only allows higher deduction in early years but does not create huge tax deduction in real terms and this deferring amount can pose a huge problem for growing business as with time their income increase and they will fall in higher tax bracket and have to pay a higher amount.
#3 – Recaptured Deprecation Risk
Under this method, you can sell of the asset once full depreciation is shown on papers but in reality, the asset is still having a useful life as it is not completely worn out it still possess economic value.
In such scenarios, the income tax department will take back the deductions as it was not fully depreciated so this will become a loss-making scenario.
This has been a guide to Accelerated Depreciation Method. Here we discuss how to calculate the accelerated depreciation expense (double declining and sum of year digit) along with its advantages and disadvantages. You may also have a look at the following accounting articles-
- Land Depreciation in Accounting
- Depreciation vs Amortization – Explain the differences
- Limitations of Financial Ratio Analysis
- What is EBITDA Formula?
The post Accelerated Depreciation appeared first on Learn Investment Banking: Financial Modeling Training Courses Online.