Accelerated depreciation
Encyclopedia
Accelerated depreciation refers to any one of several methods by which a company, for 'financial accounting' or tax
purposes, depreciates
a fixed asset
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 generally used when an asset
is expected to be much more productive during its early years, so that depreciation expense
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 by reducing taxable income
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 purposes, the two most popular methods of accelerated depreciation are the 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
).
s: revenue
s minus expense
s. There are various types of expenses, including salaries paid to workers, cost of inputs, and amortization
and depreciation
. Profits for tax purposes will, in most countries, differ from accounting profits or earning
s.
Under both financial accounting and tax accounting, companies are not allowed to claim the entire cost of a capital asset
(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).
that costs $1,000 that is expected to last for 10 years. Under the most simple form of depreciation, the company might allocate $100 of the cost of the generator to its expenses every year, until the $1000 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
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
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.)
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
purposes, depreciates
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
a fixed asset
Fixed asset
Fixed assets, also known as a non-current asset or as property, plant, and equipment , is a term used in accounting for assets and property which cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as liquid assets...
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 generally used when an asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
is expected to be much more productive during its early years, so that depreciation expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
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 by reducing taxable income
Taxable income
Taxable income refers to the base upon which an income tax system imposes tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. The amounts included as income, expenses, and other deductions vary by country or system. Many systems provide that...
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 purposes, the two most popular methods of accelerated depreciation are the 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
MACRS
The Modified Accelerated Cost Recovery System is the current tax depreciation system in the United States. Under this system, the capitalized cost of tangible property is recovered over a specified life by annual deductions for depreciation. The lives are specified broadly in the Internal...
).
Background
Companies in many countries pay taxes on profitProfit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
s: revenue
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
s minus expense
Expense
In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...
s. There are various types of expenses, including salaries paid to workers, cost of inputs, and amortization
Amortization
Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...
and depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
. Profits for tax purposes will, in most countries, differ from accounting profits or earning
Earning
Earning can refer to:*Labour *Earnings of a company*Merit...
s.
Under both financial accounting and tax accounting, companies are not allowed to claim the entire cost of a capital asset
Capital asset
The term capital asset has three unrelated technical definitions, and is also used in a variety of non-technical ways.*In financial economics, it refers to any asset used to make money, as opposed to assets used for personal enjoyment or consumption...
(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.
Additional factors
Because of the time-value of money, there is a significant tax benefit to the company for using accelerated depreciation methods. By freeing up cash flow and reducing the effective cost of the asset, it encourages companies to buy more equipment, all else being equal. Further, accelerated depreciation acts as a form of debt-free leverage, by essentially borrowing money, tax-free and risk-free, from the government (in terms of up-front tax deductions). There is no evidence, however, that accelerated depreciation leads to higher overall tax revenue for the government.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
Renewable energy
Renewable energy is energy which comes from natural resources such as sunlight, wind, rain, tides, and geothermal heat, which are renewable . About 16% of global final energy consumption comes from renewables, with 10% coming from traditional biomass, which is mainly used for heating, and 3.4% from...
. 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 generatorElectrical generator
In electricity generation, an electric generator is a device that converts mechanical energy to electrical energy. A generator forces electric charge to flow through an external electrical circuit. It is analogous to a water pump, which causes water to flow...
that costs $1,000 that is expected to last for 10 years. Under the most simple form of depreciation, the company might allocate $100 of the cost of the generator to its expenses every year, until the $1000 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
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
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
Tax profit
Tax profit or taxable profit is used to distinguish between accounting profit or earnings...
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
Time value of money
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....
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
- DepreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
- MACRSMACRSThe Modified Accelerated Cost Recovery System is the current tax depreciation system in the United States. Under this system, the capitalized cost of tangible property is recovered over a specified life by annual deductions for depreciation. The lives are specified broadly in the Internal...
- Diminished valueDiminished valueDiminished Value is the reduction in a vehicle's market value occurring after a vehicle is wrecked and repaired, otherwise called accelerated depreciation. A reasonable person will not pay the same price for a wrecked, then repaired vehicle, as they will for a vehicle with no prior accident...
- Accelerated Depreciation (Automotive)Accelerated depreciation (automotive)Accelerated Depreciation is the lost value a vehicle carries after it’s been repaired from an accident. Accelerated Depreciation is the Canadian term used to describe the similar term in the United States, called diminished value. Although they are describing similar losses, how a person goes...