Accelerated Depreciation

What is Accelerated Depreciation?

Accelerated depreciation is referred to those methods where the asset cost is depreciated at a faster rate than the straight-line method, and therefore it leads to larger depreciation 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. Declining Balance Method and Sum of Years Digit Method are the two such popular methods.

Types of Accelerated Depreciation Method

The most commonly used methods are the Declining Balance Method of DepreciationDeclining Balance Method Of DepreciationIn declining balance method of depreciation or reducing balance method, assets are depreciated at a higher rate in the initial years than in the subsequent years. A constant depreciation rate is applied to an asset’s book value each year, heading towards accelerated depreciation.read more and Sum of year Digit Method of depreciationSum Of Year Digit Method Of DepreciationThe sum of years digits method is an accelerated depreciation method whereby the method declines the asset's value at an accelerated rate. Therefore, greater deductions are allowed in the starting life of the assets than in subsequent years.read more. 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 a double-declining depreciation method.

The basic formula to calculate depreciation using the double-declining method is

Declining Balance Method Example

An asset 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 methodStraight Line Depreciation MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more:

• Depreciation at every year = (Book Value of an asset- Salvage ValueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more)/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 year 1
• 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 the 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 implications, but it gives advantages to the firm to use.

#2 – Sum of Years 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 valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed.read more.

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 depreciationThe DepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more 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 an income statement for tax purposes.

Advantages

#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 the 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 the 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 the 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 flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more 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 the 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

#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 the 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 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 possesses economic value.

In such scenarios, the income tax department will take back the deductions as it was not a fully depreciated asset, so this will become a loss-making scenario.

Recommended Articles

This has been a guide to the Accelerated Depreciation method and its definition. 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-

• Straight Line Depreciation Method Formula
• Land Depreciation in Accounting
• Depreciation vs Amortization
• EBITDA Formula