Depreciation for Income Tax Purposes Prior to 1981, the accelerated depreciation methods described above were widely used for both financial reporting purposes and federal income tax purposes. Accelerated depreciation was popular for tax purposes because businesses could substantially reduce their taxable income in the early years of asset life by charging relatively higher amounts of depreciation expense against net income, thereby paying less tax. The income tax rules at that time specified the minimum permissible useful lives for various types of assets. The Economic Recovery Tax Act of 1981 drastically changed the depreciation rules for income tax purposes. A new method of deprecia-tion, the Accelerated Cost Recovery System (ACRS), was created by the 1981 act and became the only form of accelerated depreciation acceptable for tax purposes for assets acquired after 1981. Certain restrictions were even placed on the use of straight-line depreciation for tax pur-poses. This new system generally shortened the useful lives of most types of assets for tax purposes. It also permitted most assets to be depreciated completely; in other words, residual values were assumed to be zero. Under the 1981 act all assets were grouped into four cate-gories, only three of which were applicable to most types of busi-nesses. The useful lives of the categories ranged from 3 years for automobiles, light trucks, and certain special tools, to 15 years for buildings, with most other assets having a 5-year life. Several minor modifications to the ACRS system mainly involving the rules for depreciation of buildings were made between 1981 and 1986. Subsequently, the Tax Reform Act of 1986 changed the rules again for assets placed in service after January 1, 1987, but retained some of the major elements of the ACRS system. Automobiles, light trucks, and certain special tools became fiveyear property. Most other business assets other than buildings became seven-year property. Residential buildings are depreciated over 27.5 years, and other buildings are written off over 31.5 years. Additionally, four other categories cover various specialized assets. In general, double declining balance depreciation is used for assets with lives of 10 years or less, and straight-line depreciation is required for buildings. Given the events of the past few years, it is reasonable to assume that further modifications in the tax rules can be expected. Each so-called simplification seems to produce many more pages of regulations. A problem faced by most companies required or desiring to prepare financial statements that conform to generally accepted accounting principles (GAAP) is that the ACRS system has not been accepted by the accounting profession as a method of depreciation for financial reporting purposes. This stems from the fact that ACRS depreciation allows assets to be depreciated over periods that are frequently less than the expected useful life of the asset. As a result, most companies compute income for financial reporting purposes differently than for income for tax purposes. Accountants deal with this problem by using a procedure termed interperiod tax allocation. The illustration of this procedure is beyond the scope of this text. Many small businesses whose financial statements do not necessarily need to conform strictly to GAAP use the ACRS system to prepare their financial statements to lessen the burden of recordkeeping. Depreciation for Partial Years For simplicity the preceding illustrations of various depreciation methods all assumed that the asset was acquired at the beginning of the year. However, relatively few assets are purchased on January 1 or the first day of the fiscal year.? There are several ways of dealing with this problem, and accounting rules allow considerable flexibility as long as the procedures are followed consistently. When assets are acquired during an accounting period, one of the simplest approaches is to charge a full year of depreciation in the year of acquisition regardless of the date of acquisition. Possible variations of this approach include charging a full year of depreciation for all assets purchased during the first half of the year, and no depreciation for assets purchased during the second half of the year, or charging onehalf of the first year's depreciation for all assets purchased during the year regardless of the date of acquisition. Some companies prefer to calculate depreciation to the nearest month. This procedure is relatively simple for straight-line deprecia-tion. If one of the accelerated methods of depreciation is used, a common procedure is to multiply the annual depreciation charge by fractions corresponding to the applicable portions of the year. For example, if an asset is purchased on September 1, the annual depreciation charge for the first year is calculated by multiplying the accelerated depreciation charge by ½/2. Assets depreciated on the basis of actual use create no special problem; the depreciation charge is based on the actual use regardless of the length of time involved.