Concept of capital recovery.
Income doesn’t occur until taxpayer recovers cost of producing income.
Sale of asset or inventory: compute gain by subtracting adjusted basis (which is a recovery of the
Example: for assets providing indirect benefits, such as equipment, the cost is deducted or allocated to
Cost allocation methods.
There are three types of cost allocation; each of these is concerned with assigning the cost of an asset to
one or more accounting periods.
is the term given to the process of allocating the cost of tangible assets, such as plant,
machinery, and equipment.
is the term given to the process of allocating the cost of intangible assets, such as patents,
copyrights, and goodwill.
is the term given to the process of allocating the cost of natural resources, such as oil, gas,
minerals, and timber.
Methods in general.
Accounting conventions: as discussed below, methods have been devised to deal with depreciation for
General rules governing depreciation for tax purposes.
Section 167 provides general rule: taxpayers may deduct a reasonable allowance for the exhaustion, wear,
and tear (including a reasonable allowance for obsolescence) of property used in the trade or business or
held for the production of income.
The problem of determining what in fact is a reasonable allowance for depreciation has been a constant
source of friction between taxpayers and the IRS.
In the early years, the IRS was satisfied if the depreciation calculations (useful life and salvage
value) were reasonable, given the “facts and circumstances.”
As time passed, however, the IRS attempted to deal with the abuse that could result from a
systematic approach by merely understating the asset’s useful life and salvage value. Various systems
were established by the IRS that the taxpayer could use in lieu of the facts-and-circumstances methods
and know that his or her method would not be challenged:
1942: Bulletin F prescribed useful lives for literally thousands of assets, yet taxpayers were still
free to establish their own useful life when they believed appropriate;
1962: Revenue Procedure 62-21 issued “Depreciation Guidelines and Rules,” providing useful
lives 30-40 percent shorter than those in Bulletin F;
1971: § 1.167(a)-11 issued establishing Asset Depreciation Range (ADR) system allowing a
taxpayer to elect a useful life from a range that was up to 20 percent shorter or longer than the
guideline life. This system was made part of the law, § 167(m), by the Revenue Act of 1971
and referred to as the
Class Life System
are often used
interchangeably and sometimes are referred to as the