What is accelerated depreciation?
Accelerated depreciation is the depreciation of fixed assets at a fast rate early in their useful lives. This type of depreciation reduces the amount of taxable income early in the life of an asset, so that tax liabilities are deferred.
Later on, when most of the depreciation will have already been recognized, the effect reverses, so there will be less depreciation available to shelter taxable income. The result is that a company pays more income taxes in later years. Thus, the net effect of accelerated depreciation is the deferral of income taxes to later time periods.
A secondary reason for using accelerated depreciation is that it may actually reflect the usage pattern of the underlying assets, where they experience heavy usage early in their useful lives.
There are several calculations available for accelerated depreciation, such as the double declining balance method and the sum of the years digits method.
If a company elects not to use accelerated depreciation, it can instead use the straight-line method. where it depreciates an asset at the same standard rate throughout its useful life.
All of the depreciation methods end up recognizing the same amount of depreciation, which is the cost of the fixed asset, less any expected salvage value. The only difference between the various methods is
the speed with which depreciation is recognized.
When Accelerated Depreciation is Not Used
Accelerated depreciation requires additional depreciation calculations and record keeping, so some companies avoid it for that reason (though fixed asset software can readily overcome this issue). Companies may also ignore it if they are not consistently earning taxable income, which takes away the primary reason for using it. Companies may also ignore accelerated depreciation if they have a relatively small amount of fixed assets, since the tax effect of using accelerated depreciation is minimal. Finally, if a company is publicly held, management may be more interested in reporting the highest possible amount of net income in order to buoy its stock price for the benefit of investors - these companies will likely not be interested in accelerated depreciation, which reduces the reported amount of net income.
Financial Analysis Effects
From a financial analysis perspective, accelerated depreciation tends to skew the reported results of a business to reveal profits that are lower than would normally be the case. This is not the situation over the long-term, as long as a business continues to acquire and dispose of assets at a steady rate. To properly review a business that uses accelerated depreciation, it is better to review its cash flows, as revealed on it statement of cash flows.