Depreciation methods that enable increased costs in the early years of an asset's life are known as accelerate depreciation method for accounting or tax purposes. Depreciation costs will be greater in the early years and fall as the asset matures if you choose an accelerated depreciation technique like the double-declining balance (DDB). When it comes to calculating the cost of an item, straight-line depreciation isn't an option.
Understanding Depreciation Acceleration
These strategies tend to correlate the recognized rate of asset depreciation with its actual usage. Because modern, functional, and efficient assets get the most use, this alignment is common. The justification for using an accelerated depreciation method is that it accurately reflects how the asset is used at the beginning of its life. As an asset age, it is gradually phased out in favor of fresher ones.
Methods of Accelerated Depreciation
Method of Double-Declining Balance
Accelerated depreciation is achieved by using the DDB technique (double-declining balance). This rate is applied to the depreciable base (also known as the book value) for the remainder of the asset's estimated life after taking the reciprocal of the useful life and doubling it.
A five-year asset, for example, would have a reciprocal value of 1/5 or 20%. The asset's current book value is depreciated at 40 percent. There will be an overall drop in the dollar value over time due to a lower depreciable base each month, even when the rate remains the same.
Digits of the Years Added Up (SYD)
Accelerated depreciation is also possible with the sum-of-the-years'-digits (SYD) approach. Put all of the asset's estimated lifecycle numbers together to begin. The sum of the numerals one through five, or 1 + 2 + 3 + 4 + 5 = 15, is the base for an asset having a five-year life. 5/15 of the depreciable base is depreciated in the first year. Depreciation in the second year would be limited to just 4/15 of the base depreciation. In year five, the remaining 1/15th of the basis is depreciated.
Compared: Accelerated vs. Straight-Line Depreciation
In a straight-line depreciation technique, an asset's value steadily decreases over time. Accelerated depreciation means that the asset loses value more quickly in the early years of its life, with a more gradual decline in value as time goes on. Regardless of the technique used to depreciate an asset, the ultimate amount of depreciation should be the same for all assets. The most significant distinction between accelerated and straight-line depreciation is the order in which they occur.
Different Depreciation Methods' Financial Statement Impact
See how varied each year's depreciation is based on the various ways shown above. Accelerated techniques of depreciation such as the twofold decreasing and the sum of the years' digits cause a higher decline in the early years than the straight-line approach. Why does accelerated depreciation dramatically influence an asset's worth and a company's bottom line?
A company's stated earnings are affected by the amount of depreciation on an asset through the income statement. As a result, the accelerated depreciation techniques distort the company's earnings and show lower profits in the early years of the asset acquisition. Depreciation is reduced as the asset approaches the end of its useful life, resulting in a larger reported profit in the latter years.
Net Present Value (NPV) and Tax Benefits
In the early years of an asset's existence, companies typically adopt methods of quick depreciation to save taxes. The overall tax deductions over the asset's lifetime will be the same, regardless of the method utilized. All an accelerated technique offers is a more rapid pace of deductions. Tax savings are greater in the early years using rapid procedures but decline with time. Because company leaders consider the Time Value of Money, it's preferable to save money upfront rather than wait. It contributes to the company's Net Present Value improvement.
Benefits Of Accelerated Depreciation
Using this strategy may result in short-term tax savings. The accelerated depreciation technique allows firms to deduct larger costs in the first few years of an asset's existence than the straight-line approach. The costs are reduced as the asset is used less later in its existence.
For example, a firm in the United States must utilize straight-line depreciation on its financial statements but can employ accelerated depreciation on its income tax filings. As a result, the corporation can deduct more costs from its income tax return.
Summary
An accelerated depreciation technique has financial reporting consequences. Expenses are higher in the early periods than in the later years because depreciation is accelerated. Using an accelerated depreciation technique for tax purposes might result in a lower tax bill since income is lower in earlier periods. On the other hand, public corporations tend to avoid using accelerated depreciation procedures since it reduces short-term net profits.
