How to Use Accelerated Depreciation

Accelerated depreciation allows a company to count a higher portion of depreciation of an asset's value to the early years of the asset's use. Essentially, the company is stating the asset will be more productive immediately after it is purchased. As a result, the asset's value will depreciate faster in the beginning of its lifetime than in the end. For tax purposes, this can permit a company to defer tax payments on an asset's production for a longer period.

Depreciation of Assets

There are two ways to deduct the expense of a business asset. First, an asset can be counted toward the cost of starting a business. This is possible only in the first year of the company's operation, and all assets may be counted this way in that single year. The second model allows for capitalization of the asset. The asset is counted as part of the company's underlying value, and it is taxed as an asset, but reductions in its value can then be deducted as capital losses through depreciation. This permits a company to deduct a portion of the asset's value over time. 

Accelerated Depreciation

Accelerated depreciation models operate under the assumption that an asset loses the highest amount of its value in the first years of its life. For example, a complicated computer system will depreciate in value rapidly as it is replaced by more sophisticated technology. After 5 years, however, the value of the asset will stabilize somewhat. It no longer has value as cutting-edge technology, but it does have value due to the functions it can still perform and the underlying parts that make it operate. The value of these assets does depreciate but at a much slower rate in the future. 

Accelerated Depreciation Example

The best way to understand the model is to view an example. Imagine a moving company purchases a truck for $20,000. The truck is expected to have a lifetime of 10 years. The company could elect to depreciate the truck's capital value $2,000 each year until it is no longer usable. However, the company believes it is more accurate to say the truck will lose $5,000 in the first 5 years, and $3,000 a year for the next 5 years. 

Each year, the company earns $8,000 from its moving services. In the first five years, the company subtracts the $5,000 of depreciation, resulting in a $3,000 profit. This is taxed at 10 percent, and the company pays $300 each year. The next 5 years, the company is taxed on $5,000 of earnings, or $500 each year. This resulted in the same overall tax payment, but the company had extra cash in the first five years because it had a larger deduction during this time period.

Implication for Investors

As an investor, you will like to see a company using accelerated depreciation modeling. This gives the company more cash during the delicate start-up or expansion phases immediately after purchasing large assets. The extra cash can be used to build equity during a crucial period of the company's development. Waiting to pay the government $200 in taxes gives the company an opportunity to invest the money, earn interest or returns on the cash, and grow.

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