Accelerated depreciation
From Wikipedia, the free encyclopedia
Accelerated depreciation refers to allowing a company to depreciate an asset (such as a unit of machinery) at a higher-than-normal rate, thus reducing taxes payable. Generally, this is for corporate profit tax, although it may be applied to other taxes in some cases.
Technically, accelerated depreciation constitutes tax deferral: in theory, profit taxes will be higher in subsequent years as the deduction to reduce taxes payable in future years will be lower. Businesses generally prefer to use accelerated depreciation when available, however, due to the time value of money: money now is preferable to money in the future.
For companies that do not or would not have taxable profits, accelerated depreciation is not useful.
Some forms of accelerated depreciation may be considered subsidies.
For accounting purposes, different time periods for depreciation may be used and the term accelerated depreciation may be encountered. True accelerated depreciation refers to tax incentives, however: a firm may accelerate depreciation to improve reporting, but the test should be to match the depreciation schedule to the true value or useful life of the asset.
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Background
Companies in many countries pay taxes on profits: revenues minus expenses. There are various types of expenses, including salaries paid to workers, cost of inputs, and amortization and depreciation. Profits for tax purposes will, in most countries, differ from accounting profits or earnings.
Under both financial accounting and tax accounting, companies are not allowed to claim the entire cost of a capital asset (any asset which can be used for many years) as an expense immediately. They must amortize the cost of the asset over some period, usually an approximation of the useful life of the asset.
Example
As a simple example, a company buys a generator that costs $1,000 that is expected to last for 10 years. Under the most simple form of depreciation, the company might allocate $100 of the cost of the generator to its expenses every year, until the $1000 capital expense has been "used up." Under accelerated depreciation, the company may be allowed to allocate $200 of the cost of the generator for five years.
If the company has $200 in profits per year (before consideration of the cost of the generator or any effects of debt or other factors), and the tax rate is 20%:
a) Normal depreciation: the company claims $100 in depreciation every year and has a tax profit of $100; it must pay profit tax of $20 every year. Over ten years, $200 in taxes are paid.
b) Accelerated depreciation: the company claims $200 in depreciation for the first five years, and nothing for the last five years. For the first five years, it has no taxable profit and pays no profit tax. For the last five years, the company has a tax profit of $200, and pays $40 per year in profit tax, for a total of $200.
To compare these two (simplified) cases, the company pays $200 in taxes in both instances. In the second case, it has deferred taxes to a much later period. The deferral of taxes to a later period is favourable according to the time value of money principle.
Additional factors
If the company retained the cash and invested it in a bank account, clearly it could earn interest on this deposit. Equally, the company could invest it in any other type of project. If these projects result in additional profit, the total tax paid to the government may actually be higher in nominal terms. Conversely, the company could borrow money to buy another generator, and potentially use accelerated depreciation to delay paying taxes further. Other tax effects may mean that government revenue is neutral or increases even in the short term.
In essence, accelerated depreciation can be seen as government "loaning" the company money for a limited period of time, and potentially increasing its total tax revenue in the long term. For the company, "borrowing" from the government may reduce the need for external finance (borrowing) from other sources. This government "loan" may be substantially less expensive than money from other lenders, and would not require the approval of lenders, particularly where the company's business is risky.
Governments generally provide opportunities to defer taxes where there are specific policy reasons to encourage an industry. For example, accelerated depreciation is used in some countries to encourage investment in renewable energy.
See Also
- Depreciation
- MACRS
- Cost Segregation Studies
External Links
- Cost Segregation Partners. Includes sample accelerated depreciation cost segregation report and accelerated depreciation cost segregation calculator
Categories: Taxation | Business | Generally Accepted Accounting Principles | Finance