Depreciation is a commercial expense. A company must be aware of its costs in order to be profitable. Assets depreciate when their value decreases over time until it reaches zero. Office supplies, computer hardware, industrial equipment, and other items depreciate over time. Real estate is one kind of asset that does not lose value over time.
A depreciation method called accelerated depreciation causes an asset’s value to decline more quickly than it would under a conventional depreciation approach like the straight-line method. The initial years’ experience more accelerated depreciation than the later years. Taxes can be decreased by using accelerated depreciation.
We’re sure most people know what Accelerated depreciation is, but accelerated depreciation is a more complicated version of it. Our aim is to make it easily understandable. This is exactly what we also do at a much higher level in our accounting course and tally institute in Ahmedabad from S20 training institute. SO, be sure to check it out!
Let’s take a closer look at what Accelerated Depreciation is.
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What is Accelerated Depreciation?
Early on in their useful lifespan, fixed assets depreciate more quickly due to accelerated depreciation. This kind of depreciation lowers the amount of taxable revenue early in an asset’s life, deferring tax obligations to later periods. The effect reverses later, so there will be less depreciation available to conceal taxable income once the majority of the depreciation has already been recorded. The end result is that a corporation eventually has to pay more in income taxes. As a result, the net result of accelerated depreciation is the postponement of income taxes. The fact that accelerated depreciation may genuinely match the usage pattern of the underlying assets, which involves more usage early in their useful lives, is another justification for using this concept.
Popular Accelerated Depreciation Methods
The largely common methods of accelerated depreciation are the double declining balance method and the sum of the years’ digits method.
Double Declining Method
The double-declining balance depreciation method, often known as the double depreciation method, accounts for higher depreciation in the early years of the machinery’s useful life than in the later years. This may represent a situation in which the expense of equipment is more valuable in its early years than in its later years. For instance, an automobile loses greater value the first few years after being purchased. The depreciation factor for the double-declining balance technique is double that of the straight-line expense method. The depreciation percentage, which is equal to one divided by the total number of life span years, is first calculated in order to determine the double-declining balance depreciation.
The cost of the machinery for the first year is multiplied by 2 and then multiplied by the depreciation percentage in order to calculate the double-declining balance depreciation for the first year. The machinery’s depreciation is subtracted from its initial cost in this stage to produce a new value. The machinery’s new value is then determined using this value. The new depreciation is then calculated by multiplying the machinery’s new value by twice the depreciation percentage. Every year of the complete life span years is followed by these stages.
Double declining balance = 2 x Straight-line depreciation rate x Book value at the beginning of the year
Suppose ABC Company purchases a machine for $100,000, with an estimated salvage value of $10,000 and a useful life of 5 years. The straight-line depreciation rate is 20%.
The double declining balance depreciation method calculation is:
Sum of the years’ digits method
Another accelerated depreciation method is the sum of the years’ digits method. Additionally, higher depreciation happens in the early years and a lower amount occurs in the latter years, comparable to the twofold falling depreciation approach.
In the sum of the year’s digits depreciation technique, the depreciation is calculated by dividing the asset’s remaining life by the sum of the years’ digits, which is then multiplied by the asset’s purchase price.
Start by adding up all the asset’s estimated life’s digits. An asset with a five-year life, for instance, would have a base of 1 + 2 + 3 + 4 + 5 = 15, or the sum of the digits 1 through 5.
5/15 of the depreciable base would be written off in the first year of depreciation. Only 4/15 of the depreciable base would be depreciated in the second year. This continues until the final 1/15 of the base is depreciated in year five.
Applicable percentage (%) = Number of years of estimated life remaining at the beginning of the year / SYD
SYD = n(n+1) / 2
SYD stands for sum of the years’ digit
n = number of years
Say ABC Company purchases a machine for $100,000 with an estimated salvage value of $10,000 and a useful life of 5 years. The straight-line depreciation rate is 20%.
The sum of the years’ digits method calculation is:
A Comparison of Accelerated Depreciation Methods with the Conventional Straight-Line Method
Between accelerated and straight-line depreciation, there are significant differences. A straight-line depreciation technique, as the name suggests, provides for a consistent amount to be depreciated in each period, but an accelerated depreciation approach allows for a significantly higher amount to be depreciated in the first few years. Second, the calculation of accelerated depreciation is more difficult than that of straight-line depreciation. And third, straight-line depreciation depicts utilisation more accurately than accelerated depreciation, which is less likely to reflect the real usage pattern of the underlying assets.
Compare the straight-line depreciation to the accelerated methods of depreciation using the same example of a machine worth $100,000 with an estimated salvage value of $10,000 and a usable life of five years.
A table showing the annual depreciation amounts for each approach:
An overview of each method’s end-of-year book values in a table:
The total depreciation and book value at the end of the machine’s useful life are the same for all three methods: $90,000 total depreciation and $10,000 final book value.
Financial Impact of Different Methods
The tables above show that, depending on the technique used, the amount of depreciation varies from year to year. According to financial research, accelerated depreciation tends to inflate a company’s reported results and show lower profits than would otherwise be the case. Long-term, as long as a corporation keeps buying and selling assets at a constant rate, this is not the case. Less annual depreciation is incurred as the asset nears the end of its useful life, which ultimately results in higher reported profits for the business in those later years.
To minimise taxes in the initial years of an asset’s life, businesses frequently employ quick depreciation techniques. It’s vital to remember that regardless of the method utilised, the total tax deductions over the asset’s lifetime would remain the same. The timeliness of the deductions is the only advantage of using an accelerated technique.
Rapid procedures offer greater tax savings early on and smaller benefits thereafter. It is preferable to save money sooner rather than later because business managers take the Time Value of Money into account. It aids in raising the company’s Net Present Value.
When Not to Use Accelerated Depreciation
Some businesses avoid accelerated depreciation because it necessitates more depreciation calculations and record keeping (though fixed asset software can readily overcome this issue). It may also be disregarded by businesses if they are not constantly generating taxable income, eliminating its main benefit. Because adopting accelerated depreciation has a minor tax impact, businesses with a modest amount of fixed assets may choose to disregard it. Finally, accelerated depreciation is typically avoided by publicly traded corporations because it lowers their reported income. Investors often buy down the price of a company’s stock when they observe a lower reported income figure.
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