When it comes to depreciation, no two businesses are alike. Unlike traditional straight line depreciation where the asset value is costed out to depreciation expense in equal increments over a given life expectancy, accelerated depreciation expenses the cost at higher values during the earlier accounting periods and at a lower amount towards the last half of the asset’s life expectancy.
Accelerated depreciation is calculated in several different business methods and several different tax code methods. This article introduces the reader to the two groups and the various methods within in each group.
There are four most commonly used methods of depreciation in accounting. All four are acceptable methods in accordance to Generally Accepted Accounting Principles. The primary method used by most businesses is straight line depreciation. This is not an accelerated form of depreciation.
The first accelerated method and most often used is Double Declining Balance. The second method is a system called the Sum of the Year’s Digits. The third and not as common method is referred to as the Units of Production.
The sections below explain and illustrate these four business methods of depreciation:
This method generates the exact same amount of expense per accounting cycle. When the asset is purchased, the dollar value is divided by the expected number of accounting periods the asset will be used (life expectancy). As an example, if a $12,000 asset is purchased and is expected to last 7 years, then $12,000 is divided by 84 months (7 years of 12 months). The monthly depreciation expense is $143. The annual amount is $1,714.
Double Declining Balance (DDB)
The fastest tool (other than the tax methods) used to depreciate fixed assets is the double declining balance method. With this method, the first year has the greatest overall depreciation deduction. This tool uses either the greater of traditional straight line on the remaining balance similar to the formula above or the depreciation calculated using the double declining balance formula. The formula is two steps in calculating the depreciation amount. The first step is to determine the remaining asset balance on the books and multiple this remaining balance by the times the straight line percentage.
Let’s assume a seven-year asset (equipment or a heavy truck) and first figure the seven-year straight line depreciation percentage. In year one, 1/7th of the total asset would be depreciated or 14.29% or in dollars it is 1/7th of $12,000 or $1,714. Under the double declining balance formula, we double the straight line and we have 28.57% figure that will be used in each year in our formula until the dollar amount used in straight line is greater than the formula.
The formula is 2 times the straight line value (28.57%) times the asset’s net book value (purchase price less accumulated lifetime to date depreciation). In year one, the asset has no accumulated depreciation, so therefore, the math is straight forward.
Let’s use the $12,000 asset from above and we have the following yearly depreciation amounts:
Year 1 – 28.57% X $12,000 = $3,428
Year 2 – 28.57% X (12,000 – 3.428) or 28.57% X 8,572 = $2,449
Year 3 – 28.57% X (12,000-3,428-2,449) or 28.57% X $6,123 = $1,749
Year 4 – 28.57% X (12,000-3,428-2,449-1,749) or 28.57% X 4,374 = $1,250; under the straight line formula, the remaining 4 years (Years 4-7) equals $4,374 divided by 4 or $1,094. $1,250 > $1,094
Year 5 – Straight Line Depreciation exceeds Double Declining Balance Amount, therefore the remaining three years are at a straight line amount of $1,041. Here is the math: DDB = 28.57% X ($4,374 – $1,250) = $893. SL = ($4,374 – $1,250)/3 remaining years which equals $3,124/3 years = $1,041. Since the remaining straight line amount is greater than the DDB, the method converts to the remaining straight line calculation.
Year 6 – $1,041
Year 7 – $1,041
For the formula to be successful, you have to convert to the SL calculation because the DDB will not fully depreciate the asset in the seven-year life expectancy. This is because you are only taking 28.57% of the remaining balance, thus always leaving some value to carry forward to another period.
Sum of the Year’s Digits
This method loads more depreciation expense (accelerated) to the income statement during the earlier periods of use and a lesser amount at the back-end of the life expectancy of the asset. It the asset is expected to last seven years, then the sum of the year’s digits equals 7+6+5+4+3+2+1 or 28. In year one, we take the highest number of the year’s digits and divide it by the total. The percentage to take as depreciation is the maximum amount and with each following year, the overall percentage continues to decrease where in the final year, we would take 1/28th of the value as the final depreciation amount. The following table illustrates the formula:
Year 1 = (7 / 28) = 25% = $3,000
Year 2 = (6 / 28) = 21.4% = 2,568
Year 3 = (5 / 28) = 17.86% = 2,143
Year 4 = (4 / 28) = 14.29% = 1,715
Year 5 = (3 / 28) = 10.7% = 1,284
Year 6 = (2 / 28) = 7.14% = 857
Year 7 = (1 / 28) = 3.6% = 432
Total amount depreciated equals 99.997% (rounding error).
The reasoning for this formula relates to the old belief that any new asset loses most of its value instantly because it is now a used asset. Similar to the popular notion of the new car losing 20% of its value the moment you pull out of the new car lot.
Units of Production
This form of accelerated depreciation uses production to determine depreciation. When an asset is purchased, there is some engineering formula to determine the number of units the asset will produce throughout the machine’s life. Typically newer equipment can produce more units during the earlier years of its life and as the machine ages, production decreases due to wearing out of parts and the fact that maintenance requires more time decreasing the availability of the equipment for production. Think of this as similar to you or me. As we age, we can’t physically produce like we did when we were in our twenties. I can’t run as fast, carry as much weight and I need more frequent breaks to hydrate and deal with muscle spasms etc. Therefore, my production decreases as I age.
This form of depreciation is slightly weighted above the straight line calculation. In most cases this calculation results in a value between SYD and SL depreciation. The following is an example of this form of depreciation.
The widget factory purchased another widget maker for $12,000. It is expected to produce around 210,000 units over seven years. The machine has the ability to produce up to 42,000 units in one year. The engineers determined the uptime as follows over the seven-year period:
Year 1 – 100% = 42,000 units = 20%
Year 2 – 93% = 39,060 units = 18.60%
Year 3 – 87% = 36,540 units = 17.40%
Year 4 – 61% = 25,620 units = 12.20%
Year 5 – 55% = 23,100 units = 11.00%
Year 6 – 54% = 22,680 units = 10.80%
Year 7 – 50% = 21,000 units = 10.00%
Total expected production is 210,000 units. Based on this information, each year of depreciation equals the expected annual production for that year as a percentage of 210,000 units, then multiple these percentages by $12,000. The result is the depreciation dollar value.
Year 1 – 100% = 42,000 units = 20% = $2,400
Year 2 – 93% = 39,060 units = 18.60% = $2,232
Year 3 – 87% = 36,540 units = 17.40% = $2,088
Year 4 – 61% = 25,620 units = 12.20% = $1,464
Year 5 – 55% = 23,100 units = 11.00% = $1,320
Year 6 – 54% = 22,680 units = 10.80% = $1,296
Year 7 – 50% = 21,000 units = 10.00% = $1,200
Total depreciation in the seven years equals $12,000.
The following graph illustrates the four methods above. Note how each of the accelerated methods provide more depreciation in the early years and significantly less in the later years.
Back in 1980, the tax code changed to allow the small business owner depreciation at an accelerated rate. In those days, the upper tax brackets were above 50%, so a higher deduction for depreciation for tax purposes allowed the owner of the business to save more by paying less tax. Congress authorized the use of the Accelerated Cost Recovery System (ACRS).
However, under President Reagan, the Code was changed in 1986 and the income tax rates were reduced in exchange for increases in some areas of the tax code. To offset this big reduction in the income tax rates some concessions were made for accelerated depreciation. So Congress enacted the Modified Accelerated Cost Recovery System (MACRS). MACRS is explained below.
In general the code allows several different depreciation methods for a business. The following are the most commonly used in the small business environment:
This is a per year allowed amount for equipment purchased by the small business during the tax year. In years 2010 through 2013 Congress has authorized up to $500,000 in accelerated depreciation in a lump sum format for purchases. If your company purchased a $12,000 widget maker, you are allowed to take the entire $12,000 in one lump sum on the tax return. The goal is to keep cash in the pocket of the small business by increasing the allowed deduction reducing the tax obligation for the small business owner.
Declining Balance Method
This is exactly like the DDB describe in the business methods above. This method is allowed for 3, 5, 7 and 10 year types of property (classification of property under the code). However, the IRS limits two classes of property to a 150 percent multiplier i.e. 1.5 times the straight line amount – for 15 or 20 year classes of property.
Modified Accelerated Cost Recovery System (MACRS)
This form of accelerated depreciation is allowed for tangible personal property; in effect just about anything you buy that is not real estate related.
The IRS classes property into several different groups. The most common are the 3, 5 and 7 year groupings. Examples for each group are presented here:
3 Year – “Rent to Own televisions, furniture”, tractors (highway rigs)
5 Year – cars, light trucks, technology equipment; geothermal, solar, wind energy equipment; computers and peripherals, and office equipment, furniture, residential carpet, retail shelving, construction equipment/tools
7 Year – Desks, file cabinets, communication equipment, fishing boats, aircraft, manufacturing equipment
To compare to the business model above, I will use the seven-year depreciation percentages for MACRS and the corresponding depreciation deduction based on a $12,000 asset.
Year 1 – 14.29% = $1,715
Year 2 – 24.49% = $2,939
Year 3 – 17.49% = $2,099
Year 4 – 12.49% = $1,499
Year 5 – 8.93% = $1,072
Year 6 – 8.92% = $1,070
Year 7 – 8.93% = $1,073
Year 8 – 4.46% = $535
Notice that seven-year property is depreciated over 8 years? Well, the IRS uses a concept of half-year in the first year and half-year in the final year in calculating depreciation with most of their respective methods. For now, just accept this. I’ll write more about this issue in another article.
If you look at the numbers closely, you’ll see this mimics a combination of the DDB and the SYD methods above. In year five, the formula converts to a straight line amount similar to the DDB method. The earlier years appear comparable to the SYD method.
Summary – Accelerated Depreciation
Accelerated depreciation is a form of accounting allowing the business to expense the fixed asset cost at a higher dollar value than traditional straight line. Its use is warranted in many situations, mostly due to the devaluation of an asset when it goes from new to used – similar to a new car being driven off the lot right after purchase. The other primary purpose of accelerated depreciation is associated with taxes. In this area of business the additional depreciation reduces the tax obligation of the small business owner allowing for more cash available to use in the business for growth or other purposes.
Both business and tax accelerated depreciation use methods like Double Declining Balance, Sum of the Year’s Digits and others. The key for the owner is to understand the different methods and elect to use the one most appropriate for his business. Act on Knowledge.