What is Accelerated Depreciation?
In accounting, Accelerated Depreciation is used to allocate the cost of a tangible asset over its useful life. Unlike straight-line depreciation, where the cost is spread evenly over each period, accelerated depreciation allows for a higher depreciation expense in the earlier years of an asset’s life and a lower expense in the later years.
Importance in Accounting:
- Matching Principle: It helps align the expenses with the revenue generated by the asset, adhering to the matching principle in accounting. Expenses are recognized in the same period as the revenue they help generate.
- Tax Purposes: Accelerated depreciation allows businesses to deduct a larger portion of the asset’s cost in the earlier years. This can result in tax savings because it reduces taxable income during those years.
- Reflects Realistic Wear and Tear: Certain assets, especially machinery or vehicles, may experience more significant wear and tear in their initial years of use. Accelerated depreciation more accurately reflects the actual asset value decline over time.
Advantages of Accelerated Depreciation Method:
- Tax Savings: It can provide businesses with higher tax deductions in the earlier years, leading to reduced taxable income and, consequently, lower tax liabilities.
- Cash Flow Benefits: Higher depreciation expenses in the short term mean lower reported profits, which can be advantageous for cash flow management.
- Matched with Asset Performance: Some assets genuinely lose their value more rapidly in the initial years, and accelerated depreciation aligns with the economic reality of the asset’s wear and tear.
Disadvantages of Accelerated Depreciation Method:
- Book Value Issues: It leads to a lower book value for the asset in the earlier years. This might not accurately represent the asset’s true market value, which could concern investors and creditors.
- Complexity: Double declining balance or sum-of-the-years-digits, can be more complex to calculate and manage than straight-line depreciation.
- Lower Depreciation in Later Years: While advantageous in the short term, lower depreciation expenses in the later years may not align with the actual maintenance costs of the asset.
Example of a Wholesaler or Retailer Business:
Let’s consider a retailer that purchases a delivery truck for $50,000 with an expected useful life of 5 years. Using the double declining balance method, the annual depreciation will be:
- Year 1: (2/5) * $50,000 = $20,000
- Year 2: (2/5) * ($50,000 – $20,000) = $12,000
- Year 3: (2/5) * ($50,000 – $20,000 – $12,000) = $7,200
- Year 4: (2/5) * ($50,000 – $20,000 – $12,000 – $7,200) = $4,320
- Year 5: (2/5) * ($50,000 – $20,000 – $12,000 – $7,200 – $4,320) = $2,592
In this example, you can see that the depreciation expense is higher in the earlier years, reflecting the accelerated nature of the method.
