Accelerated depreciation
Accelerated depreciation is an accounting method that allows businesses to write off the cost of an asset more quickly in the early years of its useful life compared to the traditional straight-line method [1]. Under accelerated depreciation the annual depreciation expense is higher during the first years after an asset is acquired and decreases over time. This approach is based on the assumption that many assets are more productive and generate more revenue when they are new and their efficiency declines as they age.
Historical development
The concept of accelerated depreciation became part of United States tax law in 1954 when Congress authorized the use of declining balance and sum of years digits methods [2]. Before this change only the straight-line method was permitted for tax purposes. The Economic Recovery Tax Act of 1981 introduced the Accelerated Cost Recovery System (ACRS) which was a major expansion of accelerated depreciation benefits for businesses.
In 1986 the Tax Reform Act replaced ACRS with the Modified Accelerated Cost Recovery System (MACRS) which remains the primary depreciation system used in the United States today [3]. MACRS establishes specific recovery periods for different classes of assets and provides predetermined depreciation percentages for each year. The system has been modified several times including the addition of bonus depreciation provisions that allow even faster write-offs of new asset purchases.
Methods of accelerated depreciation
There are several methods used to calculate accelerated depreciation each with its own formula and application [4]:
Double declining balance method
The double declining balance method (DDB) is one of the most commonly used accelerated depreciation methods. It applies a depreciation rate that is twice the straight-line rate to the declining book value of the asset each year. The formula is:
Annual Depreciation = 2 × (1 / Useful Life) × Book Value at Beginning of Year
For example if a company purchases equipment for $10,000 with a useful life of 5 years the straight-line rate would be 20% per year. Under double declining balance the rate is 40%. In the first year depreciation is $4,000 (40% of $10,000). In the second year it is $2,400 (40% of $6,000) and so on. The book value cannot be depreciated below the salvage value.
Sum of years digits method
The sum of years digits method (SYD) is another accelerated approach that calculates depreciation based on a declining fraction each year [5]. The denominator is the sum of all the digits in the useful life. For an asset with 5 year life the sum is 1+2+3+4+5=15. The numerator starts with the highest digit and decreases each year.
Annual Depreciation = (Remaining Life / Sum of Years) × (Cost - Salvage Value)
Using the same $10,000 equipment example with no salvage value the first year depreciation would be 5/15 × $10,000 = $3,333. The second year would be 4/15 × $10,000 = $2,667 and so on until the final year which is 1/15 × $10,000 = $667.
MACRS depreciation
The Modified Accelerated Cost Recovery System is required for tax purposes in the United States. MACRS assigns assets to property classes with recovery periods of 3, 5, 7, 10, 15, 20, 27.5 or 39 years depending on the type of asset [6]. The IRS publishes depreciation tables that specify the percentage of cost to be deducted each year. Most personal property uses the 200% declining balance method switching to straight-line when that provides a larger deduction.
Comparison with straight-line depreciation
Straight-line depreciation spreads the cost of an asset evenly over its useful life. Each year the same amount is deducted. In contrast accelerated methods front-load the deductions with larger amounts in early years and smaller amounts later [7].
| Year | Straight-Line | Double Declining | Sum of Years |
|---|---|---|---|
| 1 | $2,000 | $4,000 | $3,333 |
| 2 | $2,000 | $2,400 | $2,667 |
| 3 | $2,000 | $1,440 | $2,000 |
| 4 | $2,000 | $864 | $1,333 |
| 5 | $2,000 | $1,296 | $667 |
| Total | $10,000 | $10,000 | $10,000 |
The total depreciation is the same under all methods but the timing differs significantly. This timing difference has important implications for tax planning and financial reporting.
Tax benefits and considerations
Accelerated depreciation provides several tax advantages for businesses [8]:
- Tax deferral - By taking larger deductions in early years companies reduce their taxable income sooner. This defers tax payments to later years providing better cash flow.
- Time value of money - A dollar saved in taxes today is worth more than a dollar saved in the future due to the time value of money. Earlier deductions increase the present value of tax savings.
- Stimulus for investment - Accelerated depreciation encourages companies to invest in new equipment and technology because they can recover their costs faster.
However there are also considerations to keep in mind:
- Lower later deductions - The flip side of larger early deductions is that deductions in later years will be smaller. This could increase tax liability in those years.
- Book-tax differences - Many companies use straight-line for financial reporting and accelerated methods for taxes creating temporary differences that must be tracked.
- Recapture rules - If an asset is sold for more than its depreciated book value some of the accelerated depreciation may be recaptured and taxed as ordinary income.
Bonus depreciation
Bonus depreciation is a special provision that allows businesses to immediately deduct a large percentage of the purchase price of eligible assets [9]. Under the Tax Cuts and Jobs Act of 2017 businesses could deduct 100% of the cost of qualified property placed in service after September 27, 2017. This provision is being phased out with the percentage declining to 80% in 2023, 60% in 2024, 40% in 2025 and 20% in 2026.
Bonus depreciation applies to both new and used property and is taken before regular depreciation. It provides a powerful incentive for businesses to acquire assets and can significantly reduce tax liability in the year of purchase.
Applications in business decisions
Accelerated depreciation affects several areas of financial management and decision making [10]:
Capital budgeting
When evaluating investment projects companies consider the tax savings from depreciation as part of the cash flows. Accelerated depreciation increases after-tax cash flows in early years which improves metrics like net present value and internal rate of return. This can make projects more attractive and easier to justify.
Asset replacement decisions
The timing of depreciation deductions affects decisions about when to replace old equipment. An asset that is fully depreciated no longer provides tax shield benefits which may influence the decision to replace it.
Financial planning
Companies must plan for the impact of depreciation on both reported profits and tax obligations. Accelerated depreciation reduces earnings in early years which affects performance metrics and may influence stakeholder perceptions.
Advantages of accelerated depreciation
- Provides tax savings earlier when money has greater value
- Improves cash flow in the years following a major investment
- Encourages enterprises to invest in new equipment and technology
- Better matches expenses with revenue for assets that are more productive when new
- Reduces the risk of obsolescence losses by recovering costs faster
Limitations of accelerated depreciation
- Creates complexity in tracking book-tax differences
- May result in higher tax payments in later years
- Does not reflect actual wear and tear for many types of assets
- Requires more sophisticated record keeping than straight-line
- Recapture rules can reduce benefits if assets are sold early
- International companies may face challenges with different depreciation rules in various jurisdictions
| Accelerated depreciation — recommended articles |
| Cost — Tax — Investment — Financial management — Profit — Enterprise — Company — Tangible asset |
References
- Internal Revenue Service (2024), Publication 946: How To Depreciate Property.
- Kieso D.E., Weygandt J.J., Warfield T.D. (2019), Intermediate Accounting, Wiley, 17th edition.
- Warren C.S., Reeve J.M., Duchac J. (2018), Accounting, Cengage Learning, 27th edition.
- Congressional Research Service (2023), The Section 179 and Section 168(k) Expensing Allowances.
- Wall Street Prep (2023), Double Declining Balance Method (DDB) Formula and Calculator.
Footnotes
- Warren C.S., Reeve J.M., Duchac J. (2018), pp. 412-418
- Internal Revenue Service (2024)
- Congressional Research Service (2023), pp. 2-5
- Kieso D.E., Weygandt J.J., Warfield T.D. (2019), pp. 579-585
- Wall Street Prep (2023)
- Internal Revenue Service (2024)
- Warren C.S., Reeve J.M., Duchac J. (2018), pp. 415-417
- Congressional Research Service (2023), pp. 8-12
- Congressional Research Service (2023), pp. 15-20
- Kieso D.E., Weygandt J.J., Warfield T.D. (2019), pp. 586-590
Author: Sławomir Wawak