There are three basic types of depreciation used by companies when they purchase and use capital assets (computers, filing cabinets, desks etc.) One form is known as linear or straight line depreciation, in which the cost of the asset can be written off on taxes in equal amounts over the useful life of the equipment. The second is known as the reducing or declining value deduction. There are tax and other advantages to each, depending on the circumstance of the company. The third is accelerated depreciation, which can be beneficial for a number of cash-flow and government policy reasons.
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Straight Line Method
This is an easy-to-understand concept. If a company buys a piece of equipment that costs £6,500 and has an expected useful life of 10 years, the company can write off £650 per year for each of those years in depreciation. The underlying economic logic is that the depreciation represents the rate at which an asset transfers value to the business. It's not like the filing cabinet just stops working after its period of depreciation. This is the most accepted method by most economists, businesses and the IRS.
The Declining Balance Method
This gets a little more complicated. If the company purchases the some £6,500 piece of equipment, it can be depreciated by a fixed amount but once depreciated, uses the prior period's balance to determine the amount of depreciation. Using the £6,500 declining balance method a company would take a 10 per cent deduction the first year, leaving a balance going into the second year of £5,850. In the second year, a 10 per cent deduction on the balance nets a £585 deduction leaving a value of £520. Year three, the 10 per cent depreciation nets with a deduction netting £520. In the end, the total amount of deduction will be the same but it will take 2.5 times longer to recapture the capital outlay. This method is more uncommon.
This is allowed by law and may, depending on a company's cash flow needs, be appropriate. In this case, a company would claim greater depreciation amounts in the earlier years, thus reducing tax liability and freeing up cash flow when a company, depending on its circumstance, may find it preferential to the other two methods. An example would be to claim a 50 per cent deduction in the first year, netting a lesser tax hit, freeing up capital for other uses. Tax deferment for many companies is advantageous because it not only frees capital for reinvestment in the company but it can also free up capital for investment earning interest until taxes are due. A second benefit on the interest it earns is that it is usually taxed at a lower rate.
The IRS and Depreciation
The U.S. Tax Code (section 168(e)(1), provides a table to determine the appropriate period of time to depreciate various types of equipment. A company isn't bound to use the accelerated depreciation method but for those that want to take advantage of the opportunity, may. If you think in terms of computers or other technology that changes rapidly it might make the most sense to claim as much depreciation as possible as quickly as possible to keep up with technological advancement.
Time Value of Money
While its clear that companies may benefit from accelerated depreciation, there is no evidence that governments will realise increased income from the tax break. However, when government has an interest in encouraging growth in certain segments of the economy, it may target the industry and particular equipment for the industry to keep pace with competitors or, in some case, surpass them. A good example early in the 21st Century might be to encourage policy decisions by companies to invest in renewable energy resources.
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