A depreciation method in which an asset loses book value at a faster (accelerated) rate than traditional depreciation methods Show
Accelerated depreciation is a depreciation method in which a capital asset reduces its book value at a faster (accelerated) rate than it would using traditional depreciation methods such as the straight-line method. Therefore, under accelerated depreciation, an asset faces greater deductions in its value in the earlier years than in the later years. Accelerated depreciation is often used as a tax-reduction strategy. Popular Accelerated Depreciation MethodsThe most popular accelerated depreciation methods are the double declining balance method and the sum of the years’ digits method. The formula for calculating depreciation using each of these methods is given below: 1. Double declining balance method:Double declining balance = 2 x Straight-line depreciation rate x Book value at the beginning of the year 2. Sum of the years’ digits method:Applicable percentage (%) = Number of years of estimated life remaining at the beginning of the year / SYD Where: SYD = n(n+1) / 2
Example of the Double Declining Balance MethodCFI Company purchases a machine for $100,000, with an estimated salvage value of $10,000 and a useful life of 5 years. The straight-line depreciation rate is 20%. The double declining balance depreciation method calculation is: Example of the Sum of the Years’ Digits MethodCFI Company purchases a machine for $100,000 with an estimated salvage value of $10,000 and a useful life of 5 years. The straight-line depreciation rate is 20%. The sum of the years’ digits method calculation is: Comparing the Accelerated Depreciation Methods with the Traditional Straight-Line MethodLet us calculate the straight-line depreciation for the same example – a machine worth $100,000, with an estimated salvage value of $10,000 and a useful life of 5 years – and compare it to the accelerated methods of depreciation. A table with the depreciation amounts each year for each method: A table with the end of year book values for each method: Under all three methods, the total depreciation and book value at the end of the machine’s useful life is the same – $90,000 in total depreciation and $10,000 in ending book, or salvage, value. Financial Statement Impact of Different Depreciation MethodsNote from the tables above that the amount of depreciation in each year is different under varying methods. With the accelerated methods of depreciation (double declining and sum of the years’ digits), there is greater depreciation in the earlier years, as compared to the straight-line depreciation method. So, how do the accelerated methods of depreciation affect an asset’s value and the company’s net income? The amount of depreciation of an asset affects the reported profits of a company (through the income statement). Therefore, the accelerated methods of depreciation skew the profits of the company and reveal lower profit in the earlier years of the asset’s acquisition. As the asset comes closer to the end of its useful life, it faces less annual depreciation, with the net effect of the company realizing a higher reported profit in those later years. For example, consider a company that generates yearly revenues of $100,000. For simplicity, assume that the only operating expense of the company is depreciation expense (no rent expense, wage expense, etc.). Notice the difference in operating income under an accelerated method of depreciation compared to a straight-line depreciation method: As illustrated in the table above, an accelerated depreciation method results in lower reported profit in earlier years but higher profit in later years as compared to a traditional straight-line depreciation method. Tax Savings and Net Present ValueCompanies often use rapid depreciation methods to reduce taxes in the early years of an asset’s life. It’s important to note that total tax deductions over the life of an asset will be the same no matter what method is used. The only benefit of an accelerated method is the timing of the deductions. Rapid methods offer more tax savings in the early years and fewer savings in later years. Since managers of businesses take the Time Value of Money into consideration, it’s better to have the savings early rather than later. It helps to improve the Net Present Value of the business. Related ReadingThank you for reading this article on Accelerated Depreciation methods and the reasons why accountants and managers use them. To keep advancing your career, the additional CFI resources below may be useful: The most common method of depreciation used on a company's financial statements is the straight-line method. When the straight-line method is used each full year's depreciation expense will be the same amount. We will illustrate the details of depreciation, and specifically the straight-line depreciation method, with the following example. Example of Straight-Line DepreciationA company has decided that it wants to use the straight-line method for reporting depreciation on its financial statements. The company purchased equipment for use in its business operation and provides the following information:
Given the above information, the straight-line depreciation expense for each full year that the asset is used will be $2,000 as calculated here: If a company's accounting year ends on December 31, the company's income statement will report the depreciation expense as follows: *Since the asset was acquired on July 1, 2020, only half of the annual depreciation expense amount is recorded in 2020 and 2025. The company's cash payment for the equipment took place on a single day in 2020 as shown here: Since depreciation expense is reported in all years from 2020 through 2025, but the cash payment took place only at the time when the equipment was purchased, each year's depreciation expense is often described as a noncash expense. Recording Straight-Line DepreciationDepreciation is recorded in the company's accounting records through adjusting entries. Adjusting entries are recorded in the general journal using the last day of the accounting period. Assuming the company prepares only annual financial statements for its years that end on December 31, the adjusting entries will be as follows: If a company issues monthly financial statements, the amount of each monthly adjusting entry will be $166.67. Visualizing the Balances in Equipment and Accumulated DepreciationNote that the account credited in the above adjusting entries is not the asset account Equipment. Instead, the credit is entered in the contra asset account Accumulated Depreciation. The use of this contra account allows the asset account Equipment to continue to report the equipment's cost, while also reporting in Accumulated Depreciation the total amount of depreciation expense that has been reported since the asset was acquired. To assist in visualizing the balances in the asset account Equipment and the related contra asset account Accumulated Depreciation as of December 31, 2021 we are providing the following T-accounts: Book Value or Carrying Value of AssetsThe combination of an asset account's debit balance and its related contra asset account's credit balance is the asset's book value or carrying value. Using the account balances in the T-accounts above, the book value or carrying value of the company's equipment as of December 31, 2021 is: When the asset's book value is equal to the asset's estimated salvage value, the depreciation entries will stop. If the asset continues in use, there will be $0 depreciation expense in each of the subsequent years. The asset's cost and its accumulated depreciation balance will remain in the general ledger accounts until the asset is disposed of. Depreciation is Based on EstimatesIt is important to realize that the amount of depreciation reported by a company is an estimated amount. The reason is that the calculation of depreciation uses the following estimates:
What Happens When an Estimated Amount ChangesFor financial statements to be relevant for their users, the financial statements must be distributed soon after the accounting period ends. To achieve this requirement, accountants must estimate some amounts. After the financial statements are distributed, it is reasonable to learn that some actual amounts are different from the estimated amounts that were included in the financial statements. Unless the differences are significant no action is required. If there is a significant change in an asset's estimated salvage value and/or the asset's estimated useful life, the change in the estimate will result in a new amount of depreciation expense in the current accounting year and in the remaining years of the asset's useful life. NOTE: A significant change in the estimated salvage value or estimated useful life will be reported in the current and remaining accounting years of the asset's useful life. Example of a Change in the Estimated Useful Life of an AssetTo illustrate a change in the estimated useful life of an asset, we will assume a company had the following situation:
Let's first review the original straight-line depreciation using the estimates in January 2016: Note in the following T-accounts that on December 31, 2019, the balance in the Equipment account is $14,000 (the cost of the equipment) and the account Accumulated Depreciation has a credit balance of $8,000: The above accounts indicate that the book value of the equipment as of December 31, 2019 is $6,000 ($14,000 – $8,000). We also know that only two years remain (2020 and 2021) in which to depreciate the remaining $6,000 of book value. Since, the estimated salvage value is $0, the remaining $6,000 is divided by the 2 years remaining = $3,000 of depreciation expense in each of the years 2020 and 2021. The adjusting entries for 2020 and 2021 are as follows: As of December 31, 2021, the Accumulated Depreciation account will look like this: Note that the depreciation amounts recorded in the years 2019 and before were not changed. Now that you have learned the basic concepts of the depreciation reported on a company's financial statement, we will move on to calculate depreciation using three additional depreciation methods:
Page 2In most depreciation methods, an asset's estimated useful life is expressed in years. However, in the units-of-activity method (and in the similar units-of-production method), an asset's estimated useful life is expressed in units of output. In the units-of-activity method, the accounting period's depreciation expense is not a function of the passage of time. Instead, each accounting period's depreciation expense is based on the asset's usage during the accounting period. Examples of Units-of-Activity DepreciationTo introduce the concept of the units-of-activity method, let's assume that a service business purchases unique equipment at a cost of $20,000. Over the equipment's useful life, the business estimates that the equipment will produce 5,000 valuable items. Assuming there is no salvage value for the equipment, the business will report $4 ($20,000/5,000 items) of depreciation expense for each item produced. If 80 items were produced during the first month of the equipment's use, the depreciation expense for the month will be $320 (80 items X $4). If in the next month only 10 items are produced by the equipment, only $40 (10 items X $4) of depreciation will be reported. Now let's illustrate the units-of-activity method of depreciation by using a different example:
Using the above information, the calculation of the units-of-activity method of depreciation begins with the following: Over the life of the equipment, the maximum total amount of depreciation expense is $10,000. However, the amount of depreciation expense in any year depends on the number of images. Whether it's a partial year or a full year is not relevant. The depreciation expense for any accounting period is calculated by multiplying the number of images produced times $2 per image. For instance, if 400 images are produced from July 1 through December 31, 2020, the depreciation for 2020 will be recorded as follows: If 900 images are produced in the year 2021, the depreciation entry for 2021 will be recorded as follows: In this example, the depreciation will continue until the credit balance in Accumulated Depreciation reaches $10,000 (the equipment's depreciable cost). If the equipment continues to be used, no further depreciation expense will be reported. The account balances remain in the general ledger until the equipment is sold, scrapped, etc. Double-Declining-Balance (DDB) DepreciationDDB is an Accelerated Method of DepreciationThe double-declining-balance (DDB) method, which is also referred to as the 200%-declining-balance method, is one of the accelerated methods of depreciation. DDB is an accelerated method because more depreciation expense is reported in the early years of an asset's useful life and less depreciation expense in the later years. The "double" or "200%" means two times straight-line rate of depreciation. For instance, if an asset's estimated useful life is 10 years, the straight-line rate of depreciation is 10% (100% divided by 10 years) per year. Therefore, the "double" or "200%" will mean a depreciation rate of 20% per year. The "declining-balance" refers to the asset's book value or carrying value (the asset's cost minus its accumulated depreciation). Recall that the asset's book value declines each time that depreciation is credited to the related contra asset account Accumulated Depreciation. Therefore, the DDB depreciation calculation for an asset with a 10-year useful life will have a DDB depreciation rate of 20%. In the first accounting year that the asset is used, the 20% will be multiplied times the asset's cost since there is no accumulated depreciation. In the following accounting years, the 20% is multiplied times the asset's book value at the beginning of the accounting year. This differs from other depreciation methods where an asset's depreciable cost is used. In DDB depreciation the asset's estimated salvage value is initially ignored in the calculations. However, the depreciation will stop when the asset's book value is equal to the estimated salvage value. NOTE: However, when it comes to taxable income and the related income tax payments, it is a different story. In the U.S. companies are permitted to use straight-line depreciation on their income statements while using accelerated depreciation on their income tax returns. You can find more information on depreciation for income tax reporting at www.IRS.gov. Example of Double-Declining-Balance DepreciationTo illustrate the double-declining-balance method of depreciation, we will use the following information:
Below is a table showing the first four years of the DDB depreciation: Note that the estimated salvage value of $8,000 was not considered in calculating each year's depreciation expense. In our example, the depreciation expense will continue until the amount in Accumulated Depreciation reaches a credit balance of $92,000 (cost of $100,000 minus $8,000 of salvage value). [In practice, companies often assume $0 salvage value and will switch from DDB to straight-line depreciation towards the end of the asset's useful life in order to fully depreciate the asset's cost.] Sum-of-the-Years'-Digits (SYD) DepreciationSYD is An Accelerated Method of DepreciationThe sum-of-the-years'-digits (SYD) depreciation method is also another form of accelerated depreciation since it results in more depreciation expense in the early years of the asset's useful life and less in the later years (as compared to the straight-line method). The "sum-of-the-years'-digits" refers to adding the digits in the years of an asset's useful life. For example, if an asset has a useful life of 5 years, the sum of the digits 1 through 5 is equal to 15 (1 + 2 + 3 + 4 + 5). An asset with a useful life of 10 years will have the following sum of its years' digits: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55 A fast way to compute the sum of the digits in the asset's useful life is to use this formula: n(n+1) divided by 2. If an asset's useful life is 10 years, then n = 10. The sum of the digits for an asset with a useful life of 10 years = 10(10+1)/2 = 10(11)/2 = 110/2 = 55. In the case of an asset with a 10-year useful life, the depreciation expense in the first full year of the asset's life will be 10/55 times the asset's depreciable cost. The depreciation for the 2nd year will be 9/55 times the asset's depreciable cost. This pattern will continue and the depreciation for the 10th year will be 1/55 times the asset's depreciable cost. Example of Sum-of-the-Years'-Digits DepreciationNow we will use the following information to calculate the SYD depreciation:
The depreciation amounts for the first five years of the asset's 10-year life under SYD depreciation method are:
1st year: 10/55 times $110,000 = $20,000 At the end of 10 years, the contra asset account Accumulated Depreciation will have a credit balance of $110,000. When this is combined with the debit balance of $115,000 in the asset account Fixtures, the book value of the fixtures will be $5,000 (which is equal to the estimated salvage value). Page 3When a depreciable asset is sold (as opposed to traded-in or exchanged for another asset), a gain or loss on the sale is likely. However, before computing the gain or loss, it is necessary to record the asset's depreciation right up to the moment of the sale. To amplify this step, assume that a retailer had recorded depreciation on its fleet of delivery trucks up to December 31. Three weeks later (on January 21), the company sells one of its older delivery trucks. The first step for the retailer is to record the depreciation for the three weeks that the truck was used in January. Example of a Gain on Sale of an AssetAfter an asset's depreciation is recorded up to the date the asset is sold, the asset's book value is compared to the amount received. For example, if an old delivery truck is sold and its cost was $80,000 and its accumulated depreciation at the date of the sale is $72,000, the truck's book value at the date of the sale is $8,000. If the retailer receives cash of $10,000 for the truck, the retailer will increase its asset cash and will remove from its assets, the truck's book value of $8,000. Hence, the retailer has a gain of $2,000. This transaction will be recorded as follows: Example of a Loss on Sale of an AssetNow let's assume that the retailer sells the truck for $5,000 (instead of $8,000). The retailer's cash will increase by $5,000 and its property, plant, and equipment section of the balance sheet will decrease by the book value of $8,000. As a result, the retailer will have a loss of $3,000. This transaction will be recorded as follows: Other Information Regarding Depreciable AssetsDepreciation of Manufacturing AssetsAssuming a retailer, distributor, or service provider does not manufacture goods, the depreciation associated with its assets will be recorded and reported on its income statement as depreciation expense. However, if a company's depreciable assets are used in a manufacturing process, the depreciation of the manufacturing assets will not be reported directly on the income statement as depreciation expense. Instead, this depreciation will be initially recorded as part of manufacturing overhead, which is then allocated (assigned) to the goods that were manufactured. In other words, the depreciation on the manufacturing facilities and equipment will be attached to the products manufactured. When the goods are in inventory, some of the depreciation is part of the cost of the goods reported as the asset inventory. When the goods are sold, some of the depreciation will move from the asset inventory to the cost of goods sold that is reported on the manufacturer's income statement. The depreciation on the non-manufacturing assets (these are assets used in the company's selling, general and administrative activities) will be reported directly as depreciation expense on the manufacturer's income statements. Repairs and Maintenance Vs. Capital ExpendituresAfter a company's asset has been put into service, there will likely be some future expenditures associated with the asset. If an expenditure merely maintains the asset (routine and preventative maintenance, tune ups, etc.), the expenditure is immediately reported as an expense such as Repairs and Maintenance Expense. Similarly, if a huge expenditure merely repairs a broken machine, the amount is reported as an expense such as Repairs and Maintenance Expense. On the other hand, if an expenditure expands or improves an asset's capabilities, the amount is not reported as an expense. Rather, the cost of the addition or improvement is recorded as an asset and should be depreciated over the remaining useful life of the asset. The amounts spent to acquire, expand, or improve assets are referred to as capital expenditures. The amount that a company spent on capital expenditures during the accounting period is reported under investing activities on the company's statement of cash flows. Depreciation: Allocation Not ValuationIt is important to understand that the main purpose of depreciation is to move the cost of an asset (except the estimated salvage value) from a company's balance sheet to depreciation expense on its income statements in a systematic manner during the asset's useful life. Hence, it is important to understand that depreciation is a process of allocating an asset's cost to expense over the asset's useful life. The purpose of depreciation is not to report the asset's fair market value on the company's balance sheets. NOTE: Impairment of Assets Used in a BusinessSince depreciation is not intended to report a depreciable asset's market value, it is possible that the asset's market value is significantly less than the asset's book value or carrying amount. The accounting profession has addressed this situation with a mechanism to reduce the asset's book value and to report the adjustment as an impairment loss. There are several steps involved in determining whether an impairment loss has occurred and how to measure and report it. You can learn more about impairment losses by reading the appropriate parts of an Intermediate Accounting textbook or visiting the Financial Accounting Standards Board's website.
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