Accelerated Depreciation Is a Great Tool
In the day to day business, there are many terms that you hear about and which often leaves you wondering about the exact meaning and implications. Not each one of us is an expert in financial terminology, but the fact is we all need to understand the basics of the fundamentals that drive businesses worldwide. One such term is accelerated depreciation.
While it is important to understand what it is and the accelerated depreciation formula, perhaps in the regular business parlance, gauging the true essence and usage of accelerated depreciation is also equally important. This is because that alone will enable effective implementation in business.
What Is Accelerated Depreciation?
In very simple terms, the accelerated depreciation definition would be the depreciation that you observe in fixed assets. This normally happens fast and sets in early while the asset is still in its useful life.
In other words, it is a method that is put into use for both accounting and also for income tax calculations. Since the depreciation sets in early on in an asset’s life, it allows for a greater amount of deduction for calculations in that time frame.
The reason why you need to understand this separately from the straight-line depreciation method is that the straight-line depreciation spreads out the cost quite evenly through the entire lifespan of the asset. In comparison, the accelerated depreciation method enables deduction of much higher expenses in the early stage of the purchases and therefore helps in lowering the expenses significantly as the depreciated items age.
In other words, when eventually the depreciation of the item is recognized, the impact reverses and the tax liability increases at that point. So accelerated depreciation early on helps reduce the overall outgo during the later days of the asset’s life. Often it is this accelerated depreciation that highlights the true usage pattern of the asset under consideration.
Accelerated Depreciation Method
The next point, of course, is the details of the accelerated depreciation formula and how one can arrive at that. It can be calculated in various ways:
1) Sum Of The Year Method
The accelerated depreciation formula, in this case, is Depreciation in year i = (n-i+1) * (total acquisition cost – salvage value)
Therefore let’s assume if you are calculating the amount of accelerated depreciation on $2 m worth of machinery that a company calculated with an estimated life of perhaps 5 years.
n! = 1+2+3+4+5 = 15
n = 5
Based on the above formula, the company will then be able to sell it for $200,000 worth of scrap parts in the same period.
2) Double Declining Method
In this case the formula used is
DDB in year i = 2 x (total acquisition cost – accumulated depreciation)
n = number of years
So what is being done is the amount that was taken as the straight line depreciation amount in the first year of the asset is used as a benchmark, and the same percentage is applied in the consecutive years to calculate the final amount.
There is a possibility when the company chooses not to use accelerated depreciation method; they can then opt for straight line method of calculating depreciation. In this case, there is a standard rate of depreciation through the life of the asset.
Essentially all the various accelerated depreciation methods end up recognizing the same amount of depreciation. The only difference is the overall speed in which it is calculated and the time when this crucial depreciation is recognized.
When Accelerated Depreciation Method Is Not Used
However, there are instances when the accelerated depreciation method is not used. This is because quite naturally,
- This needs additional calculation and record keeping
- Many software used by companies can be applied to overcome this issue
- If there is no persistent earnings taxable income liability, it might be ignored.
This is because the tax impact of this accelerated depreciation method is not huge and rather small. Another issue is the management of the publicly held companies are interested in portraying the highest amount of net income. This is because calculating and accounting for accelerated depreciation reduces the exact amount of net income.
Use of Accelerated Depreciation
Therefore it is understood that the true implication, benefit and usage of using the accelerated depreciation method is most clearly borne out in resource based companies where there is a much higher use of fixed assets. This is because in these types of companies the overall assets are mostly investment in machinery and other fixed assets that are required for the efficient functioning of the company.
For example when a resource company like a mining major buys a plot of land, the price that it pays at the most only covers the physical asset and also the estimated premium that the land will bring forth to the company going forward. But over a point of time, the land keeps losing value and its worth as the resource company continues its mining operation.
These will never regenerate on their own once extracted, but the price for it is paid already. This essentially is the depletion of assets in this case, and by calculating the accelerated depreciation, the potential loss can be accounted for. Companies may then want to price in this factor for getting benefit in terms of the tax outgo that they are liable for.
Therefore, accelerated depreciation method is a great tool to price in the variable earnings outgo and tax liability of a company. It is important for the assets to be priced in for companies to make more realistic assessment of their expenses involved and overall liability that the company has. Therefore the level of depletion can often be accounted for more accurately through this method.
The fact that straight line depletion takes a standard figure and the asset’s actual utility or depletion may vary over a point of time make it a less reliable source to account for depletion in comparison. Thus, accelerated depreciation serves the dual purpose of ascertaining the true worth as well as the exact liability of a company.