Net income provides a more accurate account of the financial status. Here’s why.
What is accelerated depreciation?
Accelerated depreciation is an accounting method used for income tax purposes that allows for greater depreciation of an asset’s value during its earlier years. While calculating depreciation in a straight line spreads its cost evenly over the course of an asset’s life, accelerated depreciation allows for higher expenses to be deducted in the first few years after the asset purchase, lowering the expenses as the asset ages.
An asset sees its heaviest use at the beginning of its life when it is still new, efficient and highly functional. The accelerated depreciation method matches the asset’s heavy use. As the asset ages, it is used less heavily and is phased out to favor a newer asset.
Several methods are used to calculate the accelerated depreciation of an asset, with the two main ones being the sum of the years’ digits (SYD) method and the double declining balance method. Companies that choose not to use accelerated depreciation use the straight-line method, where an asset depreciates at a standard rate over its lifetime. Regardless of the method used, all assets end up with the same amount of depreciation, which is recognized as the initial cost of the fixed asset minus the expected salvage value. What distinguishes one method from the next is how quickly the depreciation of the fixed asset is recognized.
Example of accelerated depreciation
- Calculating accelerated depreciation using the SYD method results in an asset seeing greater depreciation initially and less depreciation as it ages. An illustration of the SYD depreciation method is when a company buys an asset at $160,000 and expects it to be useful for five years and later be sold for $10,000. This means that the asset’s value depreciates by $150,000 over the five years of use.
Calculation of the depreciation using the SYD method utilizes the formula:
n(n+1) ÷ by 2, where n is the item’s useful life in years.
- The double declining balance method of calculating accelerated depreciation assumes that the item depreciates at twice, or 200 percent, of its straight-line rate. The declining balance is the asset’s carrying value, or book value, at the start of the accounting period. The book value refers to the cost of the asset, less the accumulated depreciation. An asset’s book value lowers when its contra-asset depreciation is added to the depreciation expense over the accounting period.
An example of the double declining balance method is when a company buys an asset on Jan. 1 for $100,000 and expects it to have no salvage value by the end of its predicted lifespan of 10 years. With this accounting method, the asset’s book value of $100,000 is multiplied by 20 percent in its first year to yield a depreciation of $20,000. This value is a debit to the Depreciated Expense and a credit to the Accumulated Depreciation of the asset.
Accelerated depreciation of assets is a concept all business owners need to understand. Although it is fairly complex, and its details are best left to a CPA or attorney, you need to know how to save on taxes by taking advantage of it. Because the regulations regarding depreciation change every year, it is important to talk to a tax professional before you purchase equipment or complete tax forms for your business.