Definition of Accelerated Depreciation
Accelerated Depreciation is the type of Depreciation method on fixed assets in which the asset gets depreciated at a faster rate as compared to normal traditional methods of Depreciation like straight-line method or written down method or in other words, and it is the depreciation method in which the book value of the asset gets reduced at the accelerated rate, i.e. at a faster rate than the normal methods of depreciation.
Explanation
There are various methods of Depreciation on fixed assets. However, in accelerated depreciation, the rate of depreciation applied on assets is higher than that of the other methods of depreciation. In accelerated depreciation, the book value of assets gets reduced at a faster rate than applying the other traditional methods of depreciation.
Generally, in accelerated depreciation, the depreciation rate in the earlier years is higher, and in later years, the rate of depreciation gets reduced compared to traditional methods. Hence the difference between the traditional and accelerated method of depreciation is the timing difference of depreciation.
Example of Accelerated Depreciation
Let’s assume company ABC ltd. ABC ltd has purchased machinery worth $500,000.The useful life of the machinery is 10 years. .ABC ltd is calculating the depreciation using two methods.
Straight Line Method of Depreciation:
| Particular | Value |
| Purchase price of the Machinery | $500,000.00 |
| The useful life of the Machinery (years) | 10 |
Solution:
Depreciation Formula = Purchase Price/ Useful Life of The Asset
- Depreciation = $500,000/10
- Depreciation = $50,000
Depreciation per year is $50,000
Accelerated Method of Depreciation
| Particular | Value |
| Purchase price of the Machinery | $500,000.00 |
| The useful life of the Machinery (years) | 10 |
Solution:
- Double declining balance method
Depreciation Formula = (Purchase Price/ Useful Life of the Asset)*2
- Depreciation = ($5,00,000/10)*2
- Depreciation = $100,000
Depreciation per year is $100,000
- Sum of years digit method
Depreciation Formula = (Number of Useful Years Remaining / Sum of Useful Years) * Purchase Cost.
- Depreciation = ((10 / (10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1)) * $5,00,000
- Depreciation = $90,909
Depreciation per year is $90,909
From the above example, it can be observed that the depreciation in the straight-line method is lower than the depreciation in the accelerated method of depreciation.
Methods of Accelerated Depreciation
Different methods are mentioned below:
- Double Declining balance method of depreciation: In this method of depreciation, the book value of asset get depreciated at the constant rate each year which is generally double the rate of depreciation which is applied in the straight-line method of depreciation, i.e. the rate of accelerated depreciation=2X the rate of depreciation in straight-line method
- Sum of years digit methods: In this method of depreciation, the remaining useful years of the asset are taken into consideration along with the total useful life of the asset.
- The formula for calculation of accelerated depreciation in this method = (number of useful years remaining/sum of useful years.)*Purchase cost
Accelerated Depreciation Deductions
- Due to the use of accelerated depreciation, the reported profit of the enterprises is lower in the earlier years, which get increased in the later part of the year. Hence the tax liability of the enterprise in the earlier years is lower than the tax liability of the enterprise in the later years. Hence, we get more tax deduction in earlier years.
- However, it must be taken into consideration that the total tax liability of the asset does not change in total. It is only the timing difference of tax payment.
- However, if we consider the time value of money, it is beneficial for the enterprise to get the income tax reduction in the earlier year as compared to the income tax deduction in a later year.
- In the case of accelerated depreciation, the asset gets fully depreciated on paper, but in reality, the asset is still in existence, and in this case, the income tax Department takes back the depreciation it has allowed earlier, which results in the loss to the enterprise.
Impact of Accelerated Depreciation
The following are the impact of Accelerated Depreciation
- It has a higher effect on manufacturing industries as compared to other lines of business.
- Apart from impacting the enterprise’s income statement, the accelerated depreciation affects the other financial ratios of the enterprise, for example, debt to asset ratio, profit margin ratio, Return on asset ratio, etc.
- The tax planning of the enterprise is also affected due to the use of accelerated depreciation. As discussed above, due to accelerated depreciation, the tax liability of the enterprise gets reduced in the present; however, it gets increased in the future. Because of this, the enterprise has to invest much time in the tax planning of the current year, taking into consideration the tax planning of the future years.
Benefits
Different benefits are mentioned below:
- Reduction in the reported net income of the enterprise: In the accelerated method of depreciation, the rate of depreciation is higher in the initial years, thus increasing the depreciation expense. So this increases the total expense amount in the income statement, and the net income gets reduced due to this higher volume of expense.
- Reduction in tax liability: As the income statement’s income is lower due to increased expenses, the tax liability of the enterprise gets reduced due to lower reported net income. So this saving in the form of tax liability can be used by the enterprise for further future projects or expansion of the current business.
- Allowance of deferred tax: Many enterprises use the accelerated method of depreciation in order to create the provision for deferral tax liability in the books of accounts of the enterprise. Due to the high deduction of depreciation in the earlier years, the enterprise’s net income gets reduced in the earlier years and increased in the later years, which results in the creation of defer tax which the enterprise is liable to pay in the future. Hence, the provision for DTL, i.e. deferred tax liability, is created in the books of accounts by the enterprise.
Disadvantages
- Unclear picture of the financial statements: In the accelerated method of depreciation, the higher expenses are reported in the earlier years, which get reduced in the later years. The assets do not get worn out, as shown in the statements due to accelerated depreciation. Hence, the investors do not get a clear picture of the organization’s financial health, which will lead to confusion in their minds about when to invest in the enterprise, thus affecting decision-making.
- Higher payment of taxes in later years: In the accelerated method of depreciation, the enterprise has to pay low tax in the initial years due to low reported income; however, contrary to the above, the income of the enterprise get increased in the later years because the depreciation expense in the later years get reduced and hence the tax liability of the enterprise in future also get increased hence in future the enterprise falls under higher tax bracket, and this can create a problem to the enterprise in the planning of its financial projects.
- The wrong reported value of the asset: In this method of depreciation, the asset gets depreciated fully on paper, and hence the enterprise cancels the asset because the economic value of the asset gets zero due to depreciation reported; however, in reality, the asset still has the value. The depreciation which was earlier allowed by the income tax department can be taken back, and this will lead to loss to the enterprise.
Conclusion
The use of accelerated depreciation by the enterprise does not give the true picture of books of accounts of the enterprise, thus affecting the decision-making of the investors. Hence to invest in the enterprise, the investor should not only rely on the income statement or the use of depreciation method by the enterprise. Like the cash flow statement, the other financial statements should also be studied before investing in the enterprise. Also, the other information like present tax liability and the expected future tax liability of the enterprise due to the use of accelerated depreciation should be thoroughly studied by the investor before investing in the enterprise.
Recommended Articles
This is a guide to Accelerated Depreciation. Here we also discuss the definition and accelerated depreciation deductions along with benefits and disadvantages. You may also have a look at the following articles to learn more –
