accelerated depreciation
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Accelerated depreciation refers to any one of several methods by which a company, for 'financial accounting' or
tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
purposes, depreciates a
fixed asset A fixed asset, also known as long-lived assets or property, plant and equipment (PP&E), is a term used in accounting for assets and property that may not easily be converted into cash. Fixed assets are different from current assets, such as cash ...
in such a way that the amount of depreciation taken each year is higher during the earlier years of an asset's life. For financial accounting purposes, accelerated depreciation is expected to be much more productive during its early years, so that depreciation
expense An expense is an item requiring an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. Fo ...
will more accurately represent how much of an asset's usefulness is being used up each year. For tax purposes, accelerated depreciation provides a way of deferring
corporate income taxes A corporate tax, also called corporation tax or company tax, is a direct tax imposed on the income or capital of corporations or analogous legal entities. Many countries impose such taxes at the national level, and a similar tax may be imposed at ...
by reducing
taxable income Taxable income refers to the base upon which an income tax system imposes tax. In other words, the income over which the government imposed tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. Th ...
in current years, in exchange for increased taxable income in future years. This is a valuable tax incentive that encourages businesses to purchase new assets. For
financial reporting Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...
purposes, the two most popular methods of accelerated depreciation are the double declining balance method and the sum-of-the-years’ digits method. For tax purposes, the allowable methods of accelerated depreciation depend on the tax law that the taxpayer is subject to. In the United States, the two currently allowable depreciation methods for tax purposes are both accelerated depreciation methods ( ACRS and
MACRS The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system in the United States. Under this system, the capitalized cost (basis) of tangible property is recovered over a specified life by annual deductions for de ...
).


Background

Companies in many countries pay taxes on profits:
revenue In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive reven ...
s minus
expense An expense is an item requiring an outflow of money, or any form of Wealth, fortune in general, to another person or group as payment for an item, service, or other category of costs. For a leasehold estate, tenant, renting, rent is an expense. Fo ...
s. There are various types of expenses, including salaries paid to workers, cost of inputs, and
amortization (tax law) In tax law, amortization refers to the cost recovery system for intangible property. Although the theory behind cost recovery deductions of amortization is to deduct from basis in a systematic manner over an asset's estimated useful economic life s ...
and
depreciation In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
. Profits for tax purposes will, in most countries, differ from
accounting profit Profit, in accounting, is an income distributed to the owner in a profitable market production process (business). Profit is a measure of profitability which is the owner's major interest in the income-formation process of market producti ...
s or
earnings Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT (earnings before intere ...
. Under both
financial accounting Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, ...
and tax accounting, companies are not allowed to claim the entire cost of a
capital asset A capital asset is defined as property of any kind held by an assessee, whether connected with their business or profession or not connected with their business or profession. It includes all kinds of property, movable or immovable, tangible or i ...
(any asset which can be used for many years) as an expense immediately. They must amortize the cost of the asset over some period, usually an approximation of the useful life of the asset. The depreciation basis is the cost incurred by the company in acquiring the asset. The useful life of the asset is determined by looking at Section 168(e)(3) of the United States Tax Code, and is known as the class life of the property. An example would be that a railroad track has a useful life of 7 years. This is not the end of the analysis however, because then it becomes necessary to look at the applicable recovery period of the property. The applicable recovery period determines the number of years over which the property should be depreciated. Section 168(e)(1) provides a table for determining the applicable recovery period. Following our 7 year railroad track, the table states that property with a useful life of more than 4 years but less than 10 years will be treated as 5 year property. Finally, it is important to determine the applicable convention for depreciation. Section 168(d)(4) of the U.S. Tax Code gives three different types: half year convention, the mid-month convention, and the midquarter convention. Conventions determine how much of the depreciation deduction the taxpayer may take the first year. This prevents taxpayers from claiming a full year's deduction when the asset has only been in service for part of the year. Governments generally provide opportunities to defer taxes where there are specific policy reasons to encourage an industry. For example, accelerated depreciation is used in some countries to encourage investment in renewable energy. Further, governments have increased accelerated depreciation methods in time of economic stress (in particular, the US government passed laws after 9–11 to further accelerate depreciation on capital assets).


Example

As a simple example, a company buys a generator that costs $1,000 that is expected to last for 10 years. Under straight-line depreciation, the most simple form of depreciation, the company allocates $100 of the cost of the generator to its expenses every year, until the $1,000 capital expense has been "used up." Under accelerated depreciation, the company may be allowed to allocate $200 of the cost of the generator for five years. If the company has $200 in profits per year (before consideration of the cost of the generator or any effects of
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
or other factors), and the tax rate is 20%: a) Normal depreciation: the company claims $100 in depreciation every year and has a tax profit of $100; it must pay tax of $20 on the $100 gain. Over ten years, $200 in taxes are paid. b) Accelerated depreciation: the company claims $200 in depreciation for the first five years, and nothing for the last five years. For the first five years, it has no taxable profit and pays no gains tax. For the last five years, the company has a gain of $200, and pays $40 per year in tax, for a total of $200. To compare these two (simplified) cases, the company pays $200 in taxes in both instances. In the second case, it has deferred taxes to a much later period. The deferral of taxes to a later period is favorable according to the
time value of money The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference. The ...
principle. (This example has been simplified for a basic demonstration of how accelerated depreciation works. It does not factor in an accurate class life, recovery period or account for convention.)


See also

*
Depreciation In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
*
MACRS The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system in the United States. Under this system, the capitalized cost (basis) of tangible property is recovered over a specified life by annual deductions for de ...
*
Diminished value Diminished value or diminution in value are the terms generally used to describe the loss in a property's market value after it was damaged in an accident and repaired. Diminished value is most often associated with automobiles but it is applicable ...
*
Accelerated Depreciation (Automotive) Diminished value or diminution in value are the terms generally used to describe the loss in a property's market value after it was damaged in an accident and repaired. Diminished value is most often associated with automobiles but it is applicable ...


References

{{Reflist *Section 168(e)(3) United States Tax Code *Section 168(e)(1) United States Tax Code *Section 168(d)(4) United States Tax Code Accounting terminology Depreciation