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Accelerated Depreciation

What it is:

Accelerated depreciation is a depreciation method whereby an


asset loses book value at a faster rate than the traditional
straight-line method. Generally, this method allows greater
deductions in the earlier years of an asset and is used to minimize
taxable income.

How it works/Example:

Let's assume Company XYZ purchases a piece of machinery for


$1,000,000, and that piece of machinery is expected to last for 10
years. If Company XYZ were using the straight-line method of
depreciation (not accelerated), each year it would simply record
on its income statement depreciation expense equal to one-tenth
of the asset's cost ($1,000,000/10 = $100,000). This method
would spread the cost of the asset out evenly over the life of the
asset.

However, if Company XYZ uses an accelerated depreciation


method, it might expense far more of the asset's cost in the first
few years and expense less cost in the later years.

The most popular accelerated depreciation methods are the Sum


of the Years Digits method and the Double Declining Balance
(DDB) method. Let's look at the DDB method first.

The formula for Double Declining Balance Depreciation is:


((cost of asset - salvage value) / years of useful life) x 2

Company XYZ's depreciation expense under the DDB method is


$100,000 x 2 = $200,000. Company XYZ is essentially expensing
20% of the asset's cost in the first year, and in each subsequent
year it will multiply that 20% by the remaining balance to be
depreciated.

In year two, the value of the asset is $1,000,000 - $200,000 =


$800,000, so the depreciation expense is $800,000 x 2 =
$160,000. Once the depreciation value is lower than the
$100,000 Company XYZ would have expensed using the straight-
line method, Company XYZ will revert to the straight-line method
for all remaining years.

Using the same asset example from above with Company XYZ,
let's look at the Sum of the Year Digits Depreciation method.

The formula for Sum of the Years Digits Depreciation is:

(Years of useful life left / (10+9+8+7+6+5+4+3+2+1)) x


(original cost - salvage value)

In year 1, Company XYZ's depreciation expense using the Sum of


the Years Digits method would be:

(10 / (10+9+8+7+6+5+4+3+2+1)) x ($1,000,000 - $0) =


$181,818
Note that no matter which accelerated depreciation method
Company XYZ uses, the total amount of depreciation expense
over time will be the same. The method of depreciation chosen by
the company is largely at the discretion of the company's
management.

Why it Matters:

When a company uses an accelerated depreciation method, it


lowers the value of its total assets on its balance sheet earlier in
the life of those assets. Many companies employ accelerated
depreciation methods when they have assets that they expect to
be more productive in their early years.

Accelerated depreciation helps companies shield income from


taxes -- after all, the higher the depreciation expense, the lower
the net income. High depreciation expenses recorded now,
however, mean less depreciation expenses recorded later -- thus
higher net income and taxes at the end of the asset's useful life.
Essentially, this means that accelerated depreciation defers taxes
for companies rather than helps companies avoid taxes.

Companies with large tax burdens might favor accelerated


depreciation methods more -- even if using those methods results
in lower net income -- because the cash saved in taxes can be
reinvested in the business or given to shareholders.
Investors should take the time to understand the assumptions and
methods companies use to calculate depreciation.