Accelerated depreciation

Accelerated depreciation refers to any one of several methods by which a company, for 'financial accounting' and/or tax

Tax

To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law.Taxes are also imposed by many subnational entities...

 purposes, depreciates

Depreciation

Depreciation is a term used in accounting, economics and finance to spread the cost of an asset over the span of several years.In simple words we can say that depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or...

 a fixed asset

Fixed asset

Fixed asset, also known as property, plant, and equipment , is a term used in accountancy for assets and property which cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as liquid assets...

 in such a way that the amount of depreciation taken each year is higher during the earlier years of an asset’s life. For financial accounting purposes, accelerated depreciation is generally used when an asset

Asset

In business and accounting, assets are economic resources owned by business or company. Anything tangible or intangible that one possesses, usually considered as applicable to the payment of one's debts is considered an asset. Simplistically stated, assets are things of value that can be readily...

 is expected to be much more productive during its early years, so that depreciation expense

Expense

In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...

 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

Taxable income

Taxable income is the portion of income that is the subject of taxation according to the laws that determine what is income and the taxation rate for that income. Generally, taxable income refers to an individual's gross income, adjusted for various deductions allowable by statute...

 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.

For financial reporting

Financial Reporting

Financial reporting is the process of preparing and distributing financial information to users of such information in various forms. The most common format of formal financial reporting are financial statements...

 purposes, 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

MACRS

The Modified Accelerated Cost Recovery System is the current method of accelerated asset depreciation required by the United States income tax code...

).

Background

Companies in many countries pay taxes on profit

Profit (accounting)

Accounting profit is the difference between price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.A key difficulty in measuring profit is in defining costs...

s: revenue

Revenue

In business, revenue or revenues is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. Some companies also receive revenue from interest, dividends or royalties paid to them by other companies...

s minus expense

Expense

In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...

s. There are various types of expenses, including salaries paid to workers, cost of inputs, and amortization

Amortization

Amortization or amortisation is the process of increasing, or accounting for, an amount over a period of time. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-,...

 and depreciation

Depreciation

Depreciation is a term used in accounting, economics and finance to spread the cost of an asset over the span of several years.In simple words we can say that depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or...

. Profits for tax purposes will, in most countries, differ from accounting profits or earning

Earning

Earning can refer to:*Labour *Earnings of a company*Merit...

s.

Under both financial accounting and tax accounting, companies are not allowed to claim the entire cost of a capital asset

Capital asset

The term capital asset has three unrelated technical definitions, and is also used in a variety of non-technical ways.*In financial economics, it refers to any asset used to make money, as opposed to assets used for personal enjoyment or consumption...

 (any asset which can be used for many years) as an expense immediately. They must amortize the cost of the asset over some period, usually an approximation of the useful life of the asset. The depreciation basis is the cost incurred by the company in acquiring the asset. The useful life of the asset is determined by looking at Section 168(e)(3) of the United States Tax Code, and is known as the class life of the property. An example would be that a railroad track has a useful life of 7 years. This is not the end of the analysis however, because then it becomes necessary to look at the applicable recovery period of the property. The applicable recovery period determines the number of years over which the property should be depreciated. Section 168(e)(1) provides a table for determining the applicable recovery period. Following our 7 year railroad track, the table states that property with a useful life of more than 4 years but less than 10 years will be treated as 5 year property. Finally, it is important to determine the applicable convention for depreciation. Section 168(d)(4) of the U.S. Tax Code gives three different types: half year convention, the mid-month convention, and the midquarter convention. Conventions determine how much of the depreciation deduction the taxpayer may take the first year. This prevents taxpayers from claiming a full year's deduction when the asset has only been in service for part of the year.

Additional factors

If the company retained the cash and invested it in a bank account, clearly it could earn interest on this deposit. Equally, the company could invest it in any other type of project. If these projects result in additional profit, the total tax paid to the government may actually be higher in nominal terms. Conversely, the company could borrow money to buy another generator, and potentially use accelerated depreciation to delay paying taxes further. Other tax effects may mean that government revenue is neutral or increases even in the short term.

In essence, accelerated depreciation can be seen as government "loaning" the company money for a limited period of time, and potentially increasing its total tax revenue in the long term. For the company, "borrowing" from the government may reduce the need for external finance (borrowing) from other sources. This government "loan" may be substantially less expensive than money from other lenders, and would not require the approval of lenders, particularly where the company's business is risky.

Governments generally provide opportunities to defer taxes where there are specific policy reasons to encourage an industry. For example, accelerated depreciation is used in some countries to encourage investment in renewable energy

Renewable energy

Renewable energy is energy generated from natural resources—such as sunlight, wind, rain, tides, and geothermal heat—which are renewable . In 2006, about 18% of global final energy consumption came from renewables, with 13% coming from traditional biomass, such as wood-burning...

.

Example

As a simple example, a company buys a generator

Electrical generator

In electricity generation, an electrical generator is a device that converts mechanical energy to electrical energy. The reverse conversion of electrical energy into mechanical energy is done by a motor; motors and generators have many similarities...

 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

Debt

Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned...

 or other factors), and the tax rate is 20%:

a) Normal depreciation: the company claims $100 in depreciation every year and has a tax profit

Tax profit

Tax profit or taxable profit is used to distinguish between accounting profit or earnings...

 of $100; it must pay tax of $20 on the $100 gain. Over ten years, $200 in taxes are paid.

b) 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

Time value of money

The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time.For example, 100 dollars of today's money invested for one year and earning 5 percent interest will be worth 105 dollars after one year...

principle.

(It should be noted that this example has been simplified for a basic demonstration of how accelerated depreciation works. It does not factor in an accurate class life, recovery period or account for convention.)