By Danielle Smyth Updated November 09, 2020
Over time, the value of a business’s assets decreases. This is referred to as the depreciation of assets, which is how businesses determine the value of physical or tangible assets throughout their life expectancy. Companies calculate depreciation for accounting and tax purposes, and they use it to reduce their taxable income. There are different ways to depreciate assets for tax purposes, and some may prove more beneficial financially than others.
US Legal shares that physical depreciation results from age and wear of a physical asset and is a constant factor. It starts right away when the item is put into use. As an example, say a business purchases a $25,000 piece of equipment. It has two choices: expense the entire $25,000 in year one or write off the equipment’s value over 10 years.
After the 10 years pass, the company may be able to undertake a physical depreciation appraisal and get salvage value (the value it is worth) for the equipment. If the item is valued at $5,000, the depreciation expense would be calculated as follows: $25,000 - $5,000/10. This equals a $2,000 depreciation expense for each year.
Also called physical depreciation, the straight-line depreciation method is the most basic and common depreciation method used for allocating capital asset costs. According to the Corporate Finance Institute, this method reduces the asset’s value uniformly during each year until salvage value is reached. To find it, you subtract the asset’s salvage value from its cost and divide it by its life expectancy.
Here is an example of straight-line depreciation: A business purchases a $200,000 asset that has an estimated $40,000 salvage value and a life expectancy of 10 years. $200,000 – $40,000 = $160,000. Divide this by 10 years, and you get $16,000. This $16,000 is the annual depreciation amount.
System Id shares that if the asset is expected to have the same efficiency throughout its expected life, you may want to select the physical deprecation method. If an asset produces more revenue in its early years, the accelerated depreciation method is better suited for this asset.
Accelerated depreciation systems allow companies to take higher tax deductions immediately. This reduces their current tax bill and is good for newer companies looking to improve short-term cash issues. Any monies saved can be reinvested in the company.
There are different accelerated depreciation methods, and the double-declining balance is one of the best known. More of the asset’s costs are depreciated when the asset is newer.
For example, if a new computer server has a 10-year life span, 25 percent of its depreciable cost could be deducted in its first year, compared to 10 percent for each year. The asset’s depreciable cost is also reduced every year by subtracting the depreciation from the year before.
All depreciation methods can boost a company’s net income and save on taxes, but they do so a bit differently. The straight-line method is basic and relatively easy to employ with fewer unknown factors to consider. Accelerated depreciation systems can be helpful for newer businesses, but using these means that the company will have lower tax deductions in the future. Accelerating deductions could lead to problems if the business grows and enters a higher tax bracket later on.
Recaptured depreciation is another possibility. This occurs when a long-term asset is sold before its estimated life expectancy and for more than the current accounting value. The IRS could take back the depreciation deductions in these cases, and any recaptured depreciation profits could be seen as taxable income.
June 13, 2022 June 13, 2022/ Steven Bragg
Accelerated depreciation is the depreciation of fixed assets at a faster rate early in their useful lives. This type of depreciation reduces the amount of taxable income early in the life of an asset, so that tax liabilities are deferred into later periods. Later on, when most of the depreciation will have already been recognized, the effect reverses, so there will be less depreciation available to shelter taxable income. The result is that a company pays more income taxes in later years. Thus, the net effect of accelerated depreciation is the deferral of income taxes to later time periods. A secondary reason for using accelerated depreciation is that it may actually reflect the usage pattern of the underlying assets, where they experience heavier usage early in their useful lives.
Depreciation Methods
There are several calculations available for accelerated depreciation, such as the double declining balance method and the sum of the years' digits method. If a company elects not to use accelerated depreciation, it can instead use the straight-line method, where it depreciates an asset at the same standard rate throughout its useful life. All of the depreciation methods end up recognizing the same amount of depreciation, which is the cost of the fixed asset, less any expected salvage value. The only difference between the various methods is the speed with which depreciation is recognized. The two main methods of accelerated depreciation are described next.
To calculate depreciation under the double declining method, multiply the asset book value at the beginning of the fiscal year by a multiple of the straight-line rate of depreciation. The double declining balance formula is:
Double-declining balance (ceases when the book value = the estimated salvage value)
2 × Straight-line depreciation rate × Book value at the beginning of the year
A variation on this method is the 150% declining balance method, which substitutes 1.5 for the 2.0 figure used in the calculation. The 150% method does not result in as rapid a rate of depreciation at the double declining method, and so is used less frequently.
Sum of the Years’ Digits Method
The sum of the years’ digits method derives a depreciation rate from the expected life of an asset. To use it, sum up the digits for each year. For an asset with a useful life of four years, the calculation would be 4+3+2+1 = 10. Then divide this total into each digit to arrive at the percentage that should be depreciated in each year. To continue with the example, this would be 40% depreciation in the first year, 30% depreciation in the second year, 20% depreciation in the third year, and 10% depreciation in the fourth and final year.
When Not to Use Accelerated Depreciation
Accelerated depreciation requires additional depreciation calculations and record keeping, so some companies avoid it for that reason (though fixed asset software can readily overcome this issue). Companies may also ignore it if they are not consistently earning taxable income, which takes away the primary reason for using it. Companies may also ignore accelerated depreciation if they have a relatively small amount of fixed assets, since the tax effect of using accelerated depreciation is minimal. Finally, publicly-held companies tend not to use accelerated depreciation, on the grounds that it reduces the amount of their reported income. When investors see a lower reported income figure, they tend to bid the price of a company’s stock downward. This is not the case for privately-held companies, which are under no pressure to report favorable net income figures to anyone. Consequently, privately-held companies are more likely to use accelerated depreciation than publicly-held ones.
Financial Analysis Effects of Accelerated Depreciation
From a financial analysis perspective, accelerated depreciation tends to skew the reported results of a business to reveal profits that are lower than would normally be the case. This is not the situation over the long-term, as long as a business continues to acquire and dispose of assets at a steady rate. To properly review a business that uses accelerated depreciation, it is better to review its cash flows, as revealed on its statement of cash flows.
Accelerated Depreciation vs. Straight-Line Depreciation
There are several differences between accelerated and straight-line depreciation. First, the amount of depreciation that can be taken in the first few years is much higher with an accelerated depreciation method, while (as the name implies) straight-line depreciation allows for a consistent amount to be depreciated in each period. Second, accelerated depreciation is more complicated to calculate than straight-line depreciation. And finally, accelerated depreciation is less likely to reflect the actual usage pattern of the underlying assets, while straight-line depreciation provides a better representation of usage.
June 13, 2022/ Steven Bragg/