Accelerated depreciation

Definition

Accelerated depreciation is an accounting method that allows a company to write off the cost of an asset more quickly than through standard straight-line depreciation. This approach front-loads the depreciation expense, resulting in higher expenses in the earlier years of an asset's life and lower expenses in later years. It can be advantageous for companies seeking to reduce taxable income in the short term and improve cash flow during the initial years of an asset's use.

5 Must Know Facts For Your Next Test

1. Accelerated depreciation methods include the double declining balance method and the sum-of-the-years'-digits method, both of which lead to larger depreciation expenses in earlier years.
2. This method is often used for assets that lose value quickly or become obsolete faster, such as technology and vehicles.
3. Companies may prefer accelerated depreciation to match higher expenses with higher revenues generated from new assets during their early productive years.
4. Accelerated depreciation can impact financial ratios, such as return on assets (ROA) and earnings before interest and taxes (EBIT), by showing lower profits initially.
5. In terms of tax planning, accelerated depreciation can help businesses defer tax payments by lowering taxable income in the early years of asset use.

Review Questions

• How does accelerated depreciation differ from straight-line depreciation in terms of financial reporting and tax implications?
  • Accelerated depreciation allows for a greater portion of an asset's cost to be expensed in the early years compared to straight-line depreciation, which spreads the expense evenly over the asset's useful life. This means that with accelerated depreciation, a company reports higher expenses initially, leading to lower net income in those years but improved cash flow. For tax purposes, this method can lower taxable income more significantly in the earlier years, providing a tax benefit by deferring taxes into later periods when profits might be lower.
• Discuss how accelerated depreciation might influence a company's decision-making regarding asset purchases and financing.
  • When considering purchasing new assets, companies may lean toward those that allow for accelerated depreciation to maximize their tax benefits and cash flow during initial operations. This can affect financing decisions as well; businesses may choose loans or leasing options that align with their goal of utilizing accelerated depreciation to reduce upfront costs. Additionally, the impact on financial ratios must be considered since higher initial expenses can affect attractiveness to investors or lenders who evaluate profitability metrics.
• Evaluate the long-term effects of using accelerated depreciation on a company's financial health and strategy.
  • While accelerated depreciation provides short-term benefits such as increased cash flow and lower taxes during early years, it can lead to a decline in reported earnings and financial ratios in those same periods. Over time, this strategy could impact investor perceptions and market value if stakeholders focus heavily on immediate profits rather than cash flow. Long-term strategies may need to account for the eventual reversal of these benefits as lower expenses are reported in later years when companies might be aiming for growth and profitability, making it essential to balance short-term gains with sustainable financial health.

Related terms

straight-line depreciation: A method of depreciating an asset evenly over its useful life, resulting in equal expense deductions each year.

book value: The value of an asset as recorded on a company's balance sheet, calculated as the original cost minus accumulated depreciation.

tax shield: A reduction in taxable income achieved through allowable deductions, such as depreciation, which lowers overall tax liability.