What is Accelerated Depreciation?
Accelerated depreciation is an accounting method that businesses can opt to use in order to deduct a larger portion of an asset’s cost in the early years of its useful life. When deployed correctly, it has the potential to unlock significant benefits.
To understand this accounting method, it is important to first understand how traditional (also known as ‘straight-line’) depreciation works, which can be understood by highlighting the distinction between Operational Expenditure (OpEx) and Capital Expenditure (CapEx) from an accounting standpoint.
OpEx vs. CapEx
OpEx, which covers items like salaries and overheads, refers to inherently short-term expenses. In this sense, the business pays and immediately receives the full value of what it is paying for. On the other hand, CapEx covers items like equipment and property, which require extended periods of time to reach their maximum utilization.
This delineation is evident in how expenses are deducted for each category. Operational Expenses are fully deductible upon expenditure and are considered immediate business expenses. Conversely, Capital Expenses are allocated evenly over their “useful life,” resulting in uniform annual deductions. This gradual allocation is referred to as “depreciation” for tangible assets, and “amortization” for intangible assets.
This makes a practical difference to the way tax is calculated at year end. Generally speaking, businesses pay taxes on profits generated from taxable income minus deductions, which can consist of OpEx, depreciation, and amortization expenses. The less a business can deduct, the larger its tax bill is likely to be.
How does Accelerated Depreciation fit in?
Unlike straight-line depreciation, which evenly distributes the value of the tangible asset over the course of its useful life, accelerated depreciation offers a different approach. It allows the business to front-load the deductions, meaning higher deductions can be taken in the initial years. These deductions then gradually decrease over time.
There are multiple types of accelerated depreciation methods, each one providing a different advantage for different business types. For example, the ‘Declining Balance Method’ allows the business to divide the straight- line rate by a chosen factor, allowing the business to expense higher amounts earlier on in the asset’s useful life.
Time Value of Money
The key advantage of accelerated depreciation lies in its ability to unlock significant amounts of cash that the business would have otherwise needed to wait to access. Based on the principle of ‘Time Value of Money’, money is more valuable today than in the future due to inflation and investment opportunities.
By expensing a larger portion of an asset’s cost in the early years, accelerated depreciation lowers the taxable income during those years. This, in turn, reduces the immediate tax liability, providing businesses with more cash flow in the short term.
In sum, businesses can benefit from the time value of their money by investing the savings from claiming larger deductions upfront back into their operations or other ventures. As a result of this strategic accounting method, these ventures have the potential to yield higher returns.
