Accelerated Depreciation Example Help

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Accelerated depreciation refers to any one of several methods by which a company, for ‘financial accounting’ or tax purposes, depreciates a fixed asset in such a way that the amount of depreciation taken each year is higher during the earlier years of an asset’s life. For financial accounting purposes, accelerated depreciation is expected to be much more productive during its early years, so that depreciation expense will more accurately represent how much of an asset’s usefulness is being used up each year. For tax purposes, accelerated depreciation provides a way of deferring corporate income taxes by reducing taxable income in current years, in exchange for increased taxable income in future years. This is a valuable tax incentive that encourages businesses to purchase new assets.
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.
 

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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 tax of $20 on the $100 gain. 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 gains tax. For the last five years, the company has a gain of $200, and pays $40 per year in 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 favorable according to the time value of money principle.
 
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