Accelerated depreciation

3 key takeaways

• Accelerated depreciation allocates higher depreciation costs to the initial years of an asset’s life.
• It provides tax benefits by reducing taxable income in the early years of asset ownership.
• Common methods include the double-declining balance method and the sum-of-the-years-digits method.

What is accelerated depreciation?

Accelerated depreciation is a technique used in accounting to allocate the cost of a tangible asset over its useful life in such a way that more depreciation expense is recognized in the early years than in the later years. This method contrasts with straight-line depreciation, where the expense is spread evenly across the asset’s useful life. Accelerated depreciation is often used for tax purposes because it allows businesses to reduce taxable income more quickly by expensing a larger portion of the asset’s cost in the initial years of ownership.

Examples of accelerated depreciation methods

• Double-declining balance method: This method doubles the rate of straight-line depreciation, applying it to the asset’s remaining book value each year. For example, if an asset has a useful life of 5 years and a straight-line depreciation rate of 20%, the double-declining balance method would use a rate of 40%.
• Sum-of-the-years-digits method: This method involves adding up the digits of the asset’s useful life to determine a depreciation fraction. For a 5-year asset, the sum of the years’ digits is 1+2+3+4+5 = 15. The depreciation fraction for each year would be 5/15 for the first year, 4/15 for the second year, and so on.

Importance of accelerated depreciation

Accelerated depreciation is important for several reasons:

• Tax benefits: By recognizing higher depreciation expenses in the early years, businesses can reduce their taxable income, leading to lower tax payments in those years.
• Cash flow improvement: The tax savings from accelerated depreciation can improve a company’s cash flow, providing more funds for reinvestment or other uses.
• Reflects asset usage: For some assets, such as machinery, which may lose value more rapidly in the initial years of use, accelerated depreciation provides a more accurate reflection of the asset’s decreasing value.

Real-world application

Consider a manufacturing company that purchases new equipment for $100,000 with a useful life of 5 years. Using the double-declining balance method, the company would apply a 40% depreciation rate (double the straight-line rate of 20%).

• Year 1: Depreciation expense = 40% of $100,000 = $40,000
• Year 2: Depreciation expense = 40% of ($100,000 – $40,000) = $24,000
• Year 3: Depreciation expense = 40% of ($100,000 – $64,000) = $14,400
• And so on, until the asset is fully depreciated.

Factors influencing the choice of accelerated depreciation

Businesses choose accelerated depreciation based on several factors:

• Asset type: Assets that lose value quickly, like technology or heavy machinery, may be better suited to accelerated depreciation.
• Tax strategy: Companies looking to minimize tax payments in the short term may prefer accelerated depreciation.
• Financial planning: Businesses planning for future investments might use accelerated depreciation to improve near-term cash flow.

Understanding accelerated depreciation helps businesses optimize their tax strategy and better manage their financial planning. To further explore related topics, you might want to learn about different depreciation methods, tax planning strategies, and the impact of depreciation on financial statements.