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Pro Forma Income Statement Assignment Depreciation NotesDepreciationIntroductionDepreciation is an income tax deduction that allows a taxpayer to recover the cost of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.Most types of tangible property (except, land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable.To be depreciable, the property must meet all the following requirements.It must be property you own.It must be used in your business or income-producing activity.It must have a determinable useful life.It must be expected to last more than one year.Property You OwnTo claim depreciation, you usually must be the owner of the property. You are considered as owning property even if it is subject to a debt.Property Used in Your Business or Income-Producing ActivityTo claim depreciation on property, you must use it in your business or income-producing activity. If you use property to produce income (investment use), the income must be taxable. You cannot depreciate property that you use solely for personal activities.1
Pro Forma Income Statement Assignment Depreciation NotesProperty Having a Determinable Useful LifeTo be depreciable, your property must have a determinable useful life. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.Property Lasting More Than One YearTo be depreciable, property must have a useful life that extends substantially beyond the year you place it in service.ResourcesThe official IRS publication dealing with depreciation is Publication 946, How To Depreciate Propertyand can be found on the IRS website www.irs.gov** Please note that depreciation is a fairly complex subject with potentially significant tax ramifications so interpretation of IRS regulations in regards to depreciation is best left to tax accountants and tax attorneys. 2
Pro Forma Income Statement Assignment Depreciation NotesCongress allows depreciation under the theory that the tax deductions encourage new capital investment, which helps the United States stay competitive. There are many forms of depreciation but the two main categories are straight-line and accelerated depreciation. Straight-line depreciationUnder straight-line depreciation the same amount of depreciation is written off each year. The way it is calculated is that an item’s sales value at the end of it’s useful life (called residual value) is deducted from its cost and then this amount is divided by the item’s useful life (useful life is an accounting measure determined by IRS guidelines and may not reflect an item’s actual life). This resulting number is taken as a non-cash expense each year which lowers income and thus income tax. It is important to note that depreciation is a non-cash expense and does not involve any cash going out of the company. Depreciate is used to partially recoup the cash that was spent on the initial purchaseof the asset.The value of a depreciable asset is it’s initial cost less any accumulateddepreciation. This value is called Book Value which is the value of the asset carried on the company’s books. This amount may be greater than or less than the asset’s true value (market value). 3
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