Accelerated Depreciation: Any depreciation method allowing for larger depreciation rates during the early years of a tangible/physical asset.
Accelerated Depreciation Details
Depreciation in accounting refers to the allocation of a physical asset’s original cost over its life expectancy or useful life. Depreciation is supposed to represent how much value of an asset after it’s been used over the years. A simple example is when you own a car. You should expect that your car’s value would decrease the longer you use it.
There are several types of accelerated depreciation, but the way they work is fundamentally similar. With accelerated depreciation, accountants reduce an asset’s book value—the value according to the book, not the real market value—at a faster rate. The accelerated rate of depreciation happens mostly in the asset’s early years and will gradually subside over time until the company has no use for the asset anymore. The value of an asset after its depreciation is complete is known as salvage value.
Companies adopt the accelerated depreciation method as a strategy to lower tax expenses. The current or carrying value of physical assets directly affects the bottom line of a company, which in turn affects the amount of tax liability. The more net income value a company has, the more taxes it needs to pay. If assets are depreciating at a constant rate, the company will incur more tax expenses over the years compared to accelerated depreciation due to higher net revenue.
Accelerated Depreciation Example
ABC Company just purchased a piece of equipment priced at $50,000. This equipment has an estimated life expectancy of 10 years and a salvage value of $5,000. Thus, the projected total depreciation throughout its life is $45,000.
We can use the conventional Straight-Line Depreciation to calculate depreciation. In this case, the constant value of depreciation would be $4500 per year—$45,000 divided by 10 years. However, the accountant of ABC Company decides to use one of the accelerated depreciation methods, namely Double-Declining Balance, to allocate the cost of the equipment over the years.
With the Double-Declining Balance method, the depreciation amount for the first year is more than doubled but will only decrease over time. To put it simply, the amount of depreciation for year one is $10,000. For year two, it’s $8,000; year three is $6,400, and so on. We will discuss how we calculate these numbers in the next section.
Types of Accelerated Depreciation
Companies may choose any method to determine their assets’ accelerated depreciation. But, the two most popular methods are Double-Declining Balance and Sum of the Years’ Digits.
- Double-Declining Balance Method
Double-Declining Balance = 2 X straight-line depreciation percentage X Book value at the beginning of the year
The formula above is the generally accepted formula to calculate Double-Declining Balance. To make things clear, let’s consider the previous example. According to the previous example, the straight-line depreciation percentage is 10% ($4,500 divided by $45,000). The book value at the beginning of the year refers to the current or carrying value at the beginning of that period.
Here’s the calculation for year one: 2 X 0.1 x $50,000 = $10,000. Afterward, the calculation for year two is: 2 X 0.1 X $40,000 = $8,000. This will go on until the asset reaches the end of its useful life.
- Sum of the Years’ Digits (SYD) Method
Applicable depreciation percentage = estimated useful life remaining in years / SYD
Where SYD = life expectancy (life expectancy + 1) / 2
This particular formula may seem a bit tricky to calculate, but it’s easier than it looks. First, we need to find SYD. If we follow the example before, the value of SYD is 10(10 + 1)/ 2 = 55. You can also opt to add up all of the year digits: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55.
The applicable depreciation percentage for the first year is 10/55; the second year is 9/55, the third year is 8/55, and so on. Finally, to find the depreciation value for each year, these numbers are multiplied to $45,000, which is the total value of depreciation (original cost – salvage value).
Significance of Accelerated Depreciation
In the right situation, utilizing accelerated depreciation can improve a company’s financial position through tax reduction. Higher depreciation in the early years means that the company has a higher expense. On paper, this will reduce the company's net income and decrease the amount of tax paid. However, since net income is reduced, this can potentially make the company less attractive to prospective investors. A company needs to consider this possibility if it wants to adopt accelerated depreciation.
Additionally, while it’s true that companies can use any method to implement accelerated depreciation, they still need to follow the generally accepted accounting principles (GAAP). GAAP allows faster depreciation in the early years to accommodate the idea that some assets lose value quickly. Companies can’t arbitrarily decrease or increase depreciation rates without proper reason.