Accelerated Depreciation - Background

Background

Companies in many countries pay taxes on profits: revenues minus expenses. There are various types of expenses, including salaries paid to workers, cost of inputs, and amortization and depreciation. Profits for tax purposes will, in most countries, differ from accounting profits or earnings.

Under both financial accounting and tax accounting, companies are not allowed to claim the entire cost of a capital asset (any asset which can be used for many years) as an expense immediately. They must amortize the cost of the asset over some period, usually an approximation of the useful life of the asset. The depreciation basis is the cost incurred by the company in acquiring the asset. The useful life of the asset is determined by looking at Section 168(e)(3) of the United States Tax Code, and is known as the class life of the property. An example would be that a railroad track has a useful life of 7 years. This is not the end of the analysis however, because then it becomes necessary to look at the applicable recovery period of the property. The applicable recovery period determines the number of years over which the property should be depreciated. Section 168(e)(1) provides a table for determining the applicable recovery period. Following our 7 year railroad track, the table states that property with a useful life of more than 4 years but less than 10 years will be treated as 5 year property. Finally, it is important to determine the applicable convention for depreciation. Section 168(d)(4) of the U.S. Tax Code gives three different types: half year convention, the mid-month convention, and the midquarter convention. Conventions determine how much of the depreciation deduction the taxpayer may take the first year. This prevents taxpayers from claiming a full year's deduction when the asset has only been in service for part of the year.