What is the Alternative Depreciation System (ADS)?
The Alternative Depreciation System (ADS) is a method of calculating the depreciation of certain types of assets in special circumstances. The ADS system is required by the Internal Revenue Service (IRS), and it typically increases the number of years over which the asset is depreciated. Therefore, it reduces the depreciation expense recorded each year.
- Alternative Depreciation System (ADS) is a method of calculating the depreciation of certain types of assets in special circumstances.
- The ADS method calculates depreciation using a straight-line method over a longer period of time relative to GDS; therefore, it reduces the depreciation expense recorded each year.
- ADS is generally used by small companies or those with high growth who do not possess enough immediate taxable income.
What is the Modified Accelerated Cost Recovery System (MACRS)?
Under the Internal Revenue Service (IRS), any business assets that are acquired after 1986 must be depreciated using MACRS. MACRS is used for depreciation for federal income tax purposes and is a popular system in the United States. It is normally used if businesses wish to accelerate the depreciation of their assets. Under the MACRS method, a larger depreciation expense can be recorded in earlier years and lower depreciation in later years of asset ownership.
There are two depreciation systems under MACRS: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is normally used in practice; however, in certain circumstances (which will be outlined later), ADS is used. Once a company uses the ADS method, it cannot shift back to GDS.
What is the General Depreciation System (GDS)?
The General Depreciation System (GDS) is the most commonly used MACRS depreciation system and uses a declining balance to depreciate assets. Under GDS, the depreciation rate is applied to the non-depreciated balance. Relative to ADS, GDS uses shorter recovery periods. The asset classes under the IRS can be subject to different recovery periods for GDS and ADS methods.
Understanding the Alternative Depreciation System (ADS)
The ADS method calculates depreciation using a straight-line method over a longer period of time relative to GDS. There are certain situations where businesses can choose to use ADS instead of GDS, and for that, they need to use the IRS Form 4562 – Depreciation and Amortization, which allows them to select which system to use (made on an asset class basis). Once a system is chosen, it cannot be changed for that asset class in the given tax year.
ADS is generally used by small companies or those with high growth who do not possess enough immediate taxable income. Using the ADS method would provide benefits to such companies over using the GDS method, as they can record lower depreciation in the earlier years, resulting in higher profitability. ADS provides for equal yearly deductions, except for the first and last years.
Uses of the ADS
The list below shows circumstances where a company may use ADS. The list, however, is not exhaustive, as there are several other conditions where ADS can be used.
In certain cases, depreciation is required to be recalculated for Alternative Minimum Tax (AMT) purposes. AMT is a separate tax that reduces the deductions of taxpayers. The ADS method must be used when making AMT adjustments. ADS is also used to compute depreciation for earnings and profits purposes.
IRS Publication 946 mentions recovery periods for different asset classes under the GDS and ADS methods. Some prominent asset recovery periods are mentioned below as examples:
- Recovery periods for cars, light trucks, and computers is five years (same under GDS and ADS).
- Business office furniture and fixtures – Straight-line recovery period of 10 years under ADS.
- Personal property with no class life – ADS recovery period of 12 years.
- Non-residential real and residential rental property – May elect ADS straight-line recovery over 40 years.
Pros and Cons of Accelerated Depreciation
Accelerated depreciation is used by several companies, and looking at historic data, the depreciation method accounts for one of the largest corporate tax expenditures. It is used by most businesses, as schedules are established to determine the depreciation rate of various assets, and the effective tax rates on investments also vary.
An advantage of accelerated depreciation is that it provides tax benefits to certain asset classes, such as the effective marginal tax rates for investments in equipment.
On the other hand, a disadvantage of accelerated depreciation is that it is considered to distort business decisions, as companies tend to overstate expenses and record higher depreciation than reality. It can affect future business decisions and cash flow allocation towards business expansion.
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