About Depreciation

In the context of solar power investments, you would have frequently come across the term Accelerated Depreciation. It would have been usually mentioned in the context of financial incentives. What exactly is Accelerated Depreciation, and how does it benefit those investing in solar?

In order to explain accelerated depreciation, let us first understand what depreciation means.

Depreciation is a financial tool used to account for the reduction in value of an asset over time. Any product’s value reduces in value over time, and this decrease in value is termed depreciation. Depreciation is thus used to convert a fixed cost (for example, an upfront, one-time payment for solar panels) into an annual expense.

So, when you buy a solar power system, due to reduction in efficiencies of solar panels and wear & tear of parts, its’ value decreases over time. As mentioned earlier, this reduction in value is captured in depreciation, where upfront capital is spread over time for tax accounting purposes. This depreciated value is made a part of expenses when you include it in your accounts, thereby affecting net income.

Therefore, depreciation affects

  1. Value of asset over time
  2. Net Income (= Income – expenses)

Example:  Let’s say your company owns a solar plant which is expected to produce useful electricity for a period of 25 years. If it costs a capital of $1 million to build the solar plant, a simple, straight-line depreciation would depreciate it at $40,000 ($1000000/25) per year for 25 years.

But what is accelerated depreciation?

But, accelerated depreciation (AD), as the name suggests, is a method of depreciation wherein the value of the solar plant (your fixed asset) reduces at a faster rate in the early years – thus, the depreciation is accelerated.

What is the key benefit of accelerated depreciation for solar energy investors? It is beneficial in reducing the taxable income during the early years of the solar power project and thus can be considered to deliver cash profits during these early years, especially the first 2 or 3 years.

Broadly, the significance of ‘accelerated depreciation’ in the context of solar industry can be considered as follows:

  • Incentivizes investment in solar
  • Accelerates profit-making by reducing the taxable income in the early years
  • Postpones higher taxes to a later period in time

An example

To appreciate the income tax benefits of AD, let’s say your company spends $1 million on a 1 MW solar PV plant. Let’s say your company/business had made a profit of $2 million in that year.

Let us assume an accelerated depreciation of 80%, which implies that you can depreciate 80% of your asset’s value in the first year. An 80% accelerated depreciation for the 1st year will bring down the taxable income to $1.2 million (Profits – Accelerated Depreciation = $2 million – (0.8*$1 million)).

If an income tax of 30% is considered, the actual money saved on income tax due to accelerated depreciation is $0.24 million (30% * 0.8). How? Without factoring the accelerated depreciation, your company would have paid taxes of $0.6 million (30%*$2 million). With AD, you pay taxes of only $0.36 million (30%*$1.2 million), and thus you have saved $0.24 million ($0.6 million – $0.36 million).

Is accelerated depreciation applicable to all anyone investing in solar?

Not exactly.

Firstly, accelerated depreciation as a financial incentive is only applicable to business entities; thus, residential solar energy investors (for solar water heaters or rooftop solar PV systems) cannot benefit from accelerated depreciation.

Even if you are running a business, accelerated depreciation is a benefit only if you are a profit making company. The reason is obvious – unless you are making profits, you are not paying taxes, and accelerated depreciation essentially is a benefit you get through the lowering of your taxes. If you are a loss making company and are not any way paying taxes, what financial difference can accelerated depreciation make?

Is accelerated depreciation unique to solar sector?

No. Accelerated depreciation as a financial incentive has been applied to many industrial sectors worldwide, and in many countries, is also available for the solar energy sector.

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