tejas.gaikwad.1044
Tejas Gaikwad
Accelerated Depreciation
Definition of accelerated depreciation.
Accelerated Depreciation refers to a method in which an organization depreciates its fixed assets in such a way that it allocates unequal amounts for each year. This primarily means that a larger portion of the cost is written-off in the earlier years while a lesser amount is left towards the end.
As depreciation is a non-cash expense, this method of depreciation is only for the financial reporting and tax purposes and has no impact on the cash flows. The benefit that a company gains out of this is that its tax expense is deferred onto a later period which is better as per the concept of time value of money.
There are several methods which can be used for the accelerated depreciation like the Double Declining Balance method (DDB), Modified Accelerated Cost Recovery System (MACRS). Accelerated depreciation is generally used for assets which are often replaced before their useful life so that they are completely written-off by the time they are replaced.
For financial accounting purposes, accelerated depreciation is expected to be much more productive during its early years, so that depreciation expense will more accurately represent how much of an asset’s usefulness is being used up each year. For tax purposes, accelerated depreciation provides a way of deferring corporate income taxes by reducing taxable income in current years, in exchange for increased taxable income in future years. This is a valuable tax incentive that encourages businesses to purchase new assets.
The two most popular methods of accelerated depreciation are the declining balance method and the sum-of-the-years’ digits method. For tax purposes, the allowable methods of accelerated depreciation depend on the tax law that the taxpayer is subject to. In the United States, the two currently allowable depreciation methods for tax purposes are both accelerated depreciation methods (ACRS and MACRS).
Example 1 :-
Cost of an asset = Rs. 1000
Useful life of the asset = 10 yrs.
As per Straight line depreciation, Depreciation per year = 1000/10 = Rs. 100
Assume tax rate = 20%
Assume profit each year = Rs. 200.
Now, company pays tax of 0.2*(200-100) = Rs. 20 each year
As per Accelerated Depreciation,
Assume that the company allocates Rs. 200 for the first five years and no depreciation in the next 5 years
Tax paid in the first five years = 0
Tax paid in the next five years = 0.2*200 = Rs. 40
Though the total tax paid is same but the tax payment has been deferred to the last five years which is significantly better as per the time value of money. Hence, depreciation serves as a tax shield.
Example 2 :-
A company buys a generator that costs $1,000 that is expected to last for 10 years. Under the most simple form of depreciation, the company might allocate $100 of the cost of the generator to its expenses every year, until the $1000 capital expense has been "used up." Under accelerated depreciation, the company may be allowed to allocate $200 of the cost of the generator for five years.
If the company has $200 in profits per year (before consideration of the cost of the generator or any effects of debt or other factors), and the tax rate is 20%:
Normal depreciation: the company claims $100 in depreciation every year and has a tax profit of $100; it must pay tax of $20 on the $100 gain. Over ten years, $200 in taxes are paid.
Accelerated depreciation: the company claims $200 in depreciation for the first five years, and nothing for the last five years. For the first five years, it has no taxable profit and pays no gains tax. For the last five years, the company has a gain of $200, and pays $40 per year in tax, for a total of $200.
To compare these two (simplified) cases, the company pays $200 in taxes in both instances. In the second case, it has deferred taxes to a much later period. The deferral of taxes to a later period is favorable according to the time value of money principle.
Definition of accelerated depreciation.
Accelerated Depreciation refers to a method in which an organization depreciates its fixed assets in such a way that it allocates unequal amounts for each year. This primarily means that a larger portion of the cost is written-off in the earlier years while a lesser amount is left towards the end.
As depreciation is a non-cash expense, this method of depreciation is only for the financial reporting and tax purposes and has no impact on the cash flows. The benefit that a company gains out of this is that its tax expense is deferred onto a later period which is better as per the concept of time value of money.
There are several methods which can be used for the accelerated depreciation like the Double Declining Balance method (DDB), Modified Accelerated Cost Recovery System (MACRS). Accelerated depreciation is generally used for assets which are often replaced before their useful life so that they are completely written-off by the time they are replaced.
For financial accounting purposes, accelerated depreciation is expected to be much more productive during its early years, so that depreciation expense will more accurately represent how much of an asset’s usefulness is being used up each year. For tax purposes, accelerated depreciation provides a way of deferring corporate income taxes by reducing taxable income in current years, in exchange for increased taxable income in future years. This is a valuable tax incentive that encourages businesses to purchase new assets.
The two most popular methods of accelerated depreciation are the declining balance method and the sum-of-the-years’ digits method. For tax purposes, the allowable methods of accelerated depreciation depend on the tax law that the taxpayer is subject to. In the United States, the two currently allowable depreciation methods for tax purposes are both accelerated depreciation methods (ACRS and MACRS).
Example 1 :-
Cost of an asset = Rs. 1000
Useful life of the asset = 10 yrs.
As per Straight line depreciation, Depreciation per year = 1000/10 = Rs. 100
Assume tax rate = 20%
Assume profit each year = Rs. 200.
Now, company pays tax of 0.2*(200-100) = Rs. 20 each year
As per Accelerated Depreciation,
Assume that the company allocates Rs. 200 for the first five years and no depreciation in the next 5 years
Tax paid in the first five years = 0
Tax paid in the next five years = 0.2*200 = Rs. 40
Though the total tax paid is same but the tax payment has been deferred to the last five years which is significantly better as per the time value of money. Hence, depreciation serves as a tax shield.
Example 2 :-
A company buys a generator that costs $1,000 that is expected to last for 10 years. Under the most simple form of depreciation, the company might allocate $100 of the cost of the generator to its expenses every year, until the $1000 capital expense has been "used up." Under accelerated depreciation, the company may be allowed to allocate $200 of the cost of the generator for five years.
If the company has $200 in profits per year (before consideration of the cost of the generator or any effects of debt or other factors), and the tax rate is 20%:
Normal depreciation: the company claims $100 in depreciation every year and has a tax profit of $100; it must pay tax of $20 on the $100 gain. Over ten years, $200 in taxes are paid.
Accelerated depreciation: the company claims $200 in depreciation for the first five years, and nothing for the last five years. For the first five years, it has no taxable profit and pays no gains tax. For the last five years, the company has a gain of $200, and pays $40 per year in tax, for a total of $200.
To compare these two (simplified) cases, the company pays $200 in taxes in both instances. In the second case, it has deferred taxes to a much later period. The deferral of taxes to a later period is favorable according to the time value of money principle.