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Chapter 6 - 6 Property Acquisitions and Cost Recovery...

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6 Property Acquisitions and Cost Recovery Deductions Learning Objectives After studying this chapter, you should be able to: 1. Describe the factors that determine if a business expenditure qualifies as a current deduction or a capital cost. 2. Define the terms tax basis and adjusted basis. 3. Explain why the use of leverage can reduce the after-tax cost of purchased assets. 4. Apply the formula to compute cost of goods sold. 5. Describe the relationship between recovery period, depreciation method, and depreciation convention in the MACRS computation. 6. Explain the benefit of and the limitations on the limited expensing election. 7. Incorporate depreciation deductions into the computation of net present value. 8. Explain how a firm recovers the cost of purchased intangibles through amortization. 9. Distinguish between cost depletion and percentage depletion. n Chapter 5, we learned that a firm's taxable income equals the excess of gross income recognized over deductible expenses for the year. If a firm has an ex- cess of deductions over gross income, the excess is a net operating loss that may be carried back or forward as a deduction in prior or future years. Of course, not every business expenditure relates solely to current year operations. If an ex- penditure results in a long-term benefit, the firm generally is not allowed to deduct the entire expenditure against current year gross income. Instead, the deduction is deferred and properly matched against the firm's future income stream. I In Chapter 6, we address this timing issue: In which taxable year or years can a firm deduct its business expenditures against gross income? The chapter begins with a discussion of the tax rules that distinguish between expenditures that qualify as current deductions and expenditures that must be capitalized. The discussion then turns to the concept of capitalized costs as the tax basis of business assets. The relationship between basis and cost recovery deductions is explored, and the impact of this relationship on cash flows is examined. The second part of the chapter
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134 Part Three The Measurement of Taxable Income focuses on the various methods by which firms recover basis as cost of goods sold or through depreciation, amortization, and depletion deductions. Deductible Expense or Capitalized Cost? Objective 1 Describe the factors that determine if a business expenditure qualifies as a current deduction or a capital cost. When a firm expends resources as part of its income-generating activity, the financial cost of the expenditure is reduced by any tax savings attributable to the expenditure. In present value terms, the tax savings are usually maximized (and the after-tax cost is minimized) if the expenditure is deductible in the current tax year. The present value of the tax savings decreases if the firm must capitalize the expenditure and postpone its de- duction until some future year. For tax accounting purposes, capitalization means that
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