What Is an Alternative Depreciation System (ADS)?

An alternative depreciation system (ADS) is one of the methods the Internal Revenue Service (IRS) requires taxpayers to use to determine the depreciation allowed on business assets. An ADS has a depreciation schedule with a longer recovery period that generally better mirrors the asset’s income streams than declining balance depreciation. If the taxpayer elects to use an alternative depreciation system, they must apply it to all property of the same class placed in service during the same year.

Understanding when to use ADS is important for business owners because accurately calculating depreciation expenses can help lower business taxes. However, the IRS rules regarding ADS can be complex. For this reason, many business owners opt to hire a tax professional to ensure they take as much depreciation expense as the IRS allows.

Understanding Alternative Depreciation System (ADS)

Depreciation is an accounting method that allows businesses to spread out the cost of a physical asset over a specified number of years, which is known as the useful life of the asset. The useful life of an asset is an estimate of the number of years a company will use that asset to help generate revenue. The IRS allows businesses to depreciate many kinds of business assets, including computers and peripherals; office furniture, fixtures, and equipment; automobiles; and manufacturing equipment.

Taxpayers who elect to use the alternative depreciation system feel that the alternative schedule will allow for a better match of depreciation deductions against income than the recovery period under the general depreciation system. While the ADS method extends the number of years an asset can be depreciated, it also decreases the annual depreciation cost. The depreciation amount is set at an equal amount each year with the exception of the first and last years, which are generally lower because they do not include a full twelve months.

Alternative Depreciation System (ADS) vs. General Depreciation System (GDS)

For property placed in service after 1986, the IRS requires that taxpayers use the Modified Accelerated Cost Recovery System (MACRS) to depreciate property. There are two methods that fall under the MACRS: the general depreciation system (GDS) and the alternative depreciation system (ADS).

The alternative depreciation system offers depreciation over a longer period of time than the general depreciation system, which is a declining balance method. The general depreciation system is often used by companies to depreciate assets that tend to become obsolete quickly and are replaced with newer versions on a fairly frequent basis. Computers and phone equipment are examples of this.

The general depreciation system allows companies to accelerate the asset’s depreciation rate by recording a larger depreciation amount during the early years of an asset’s useful life and smaller amounts in later years. The general depreciation system is more commonly used than the alternative depreciation system.

Special Considerations

The tax implications of calculating depreciation can affect a company’s profitability. For this reason, business owners need to carefully consider the pros and cons of ADS versus GDS. Since the alternative depreciation system offers depreciation over a longer course of time, the yearly deductions for depreciation are smaller than with the other method. Taxpayers who choose the alternative depreciation system schedule must use this schedule for all property of the same class that was placed in service during the taxable year.

However, taxpayers may elect the alternative depreciation system schedule for real estate on a property-by-property basis. The alternative depreciation system recovery schedule is listed in IRS Publication 946.

What Is an Amortizable Bond Premium?

The amortizable bond premium is a tax term that refers to the excess price paid for a bond over and above its face value. Depending on the type of bond, the premium can be tax-deductible and amortized over the life of the bond on a pro-rata basis.

Understanding an Amortizable Bond Premium

A bond premium occurs when the price of the bond has increased in the secondary market due to a drop in market interest rates. A bond sold at a premium to par has a market price that is above the face value amount.

The difference between the bond’s current price (or carrying value) and the bond’s face value is the premium of the bond. For example, a bond that has a face value of $1,000 but is sold for $1,050 has a $50 premium. Over time, as the bond premium approaches maturity, the value of the bond falls until it is at par on the maturity date. The gradual decrease in the value of the bond is called amortization.

Cost Basis

For a bond investor, the premium paid for a bond represents part of the cost basis of the bond, which is important for tax purposes. If the bond pays taxable interest, the bondholder can choose to amortize the premium—that is, use a part of the premium to reduce the amount of interest income included for taxes.

Those who invest in taxable premium bonds typically benefit from amortizing the premium, because the amount amortized can be used to offset the interest income from the bond. This, in turn, will reduce the amount of taxable income the bond generates, and thus any income tax due on it as well. The cost basis of the taxable bond is reduced by the amount of premium amortized each year.

In a case where the bond pays tax-exempt interest, the bond investor must amortize the bond premium. Although this amortized amount is not deductible in determining taxable income, the taxpayer must reduce their basis in the bond by the amortization for the year. The IRS requires that the constant yield method be used to amortize a bond premium every year.

Amortizing Bond Premium With the Constant Yield Method

The constant yield method is used to determine the bond premium amortization for each accrual period. It amortizes a bond premium by multiplying the adjusted basis by the yield at issuance and then subtracting the coupon interest. Or in formula form:

• Accrual = Purchase Basis x (YTM /Accrual periods per year) – Coupon Interest

The first step in calculating the premium amortization is to determine the yield to maturity (YTM), which is the discount rate that equates the present value of all remaining payments to be made on the bond to the basis in the bond.

For example, consider an investor that purchased a bond for $10,150. The bond has a five-year maturity date and a par value of $10,000. It pays a 5% coupon rate semi-annually and has a yield to maturity of 3.5%. Let’s calculate the amortization for the first period and second period.

The First Period

Since this bond makes semi-annual payments, the first period is the first six months after which the first coupon payment is made; the second period is the next six months, after which the investor receives the second coupon payment, and so on. Since we’re assuming a six-month accrual period, the yield and coupon rate will be divided by 2.

Following our example, the yield used to amortize the bond premium is 3.5%/2 = 1.75%, and the coupon payment per period is 5% / 2 x $10,000 = $250. The amortization for period 1 is as follows:

• Accrual_period1 = ($10,150 x 1.75%) – $250
• Accrual_period1 = $177.63 – $250
• Accrual_period1 = -$72.38

The Second Period

The bond’s basis for the second period is the purchase price plus the accrual in the first period—that is, $10,150 – $72.38 = $10,077.62:

• Accrual_period2 = ($10,077.62 x 1.75%) – $250
• Accrual_period2 = $176.36 – $250
• Accrual_period2 = -$73.64

For the remaining eight periods (there are 10 accrual or payment periods for a semi-annual bond with a maturity of five years), use the same structure presented above to calculate the amortizable bond premium.

Intrinsically, a bond purchased at a premium has a negative accrual; in other words, the basis amortizes.

What Is the Amortization of Intangibles?

Amortization of intangibles, also simply known as amortization, is the process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes. Intangible assets, such as patents and trademarks, are amortized into an expense account called amortization. Tangible assets are instead written off through depreciation. The amortization process for corporate accounting purposes may differ from the amount of amortization used for tax purposes.

Understanding the Amortization of Intangibles

For tax purposes, the cost basis of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset (as most intangibles don’t have a set useful life). The Internal Revenue Service (IRS) allows intangibles to be amortized over a 15-year period if it’s one of the ones included in Section 197.

Intangible assets are non-physical assets that can be assigned an economic value. Intellectual property (IP) is considered to be an intangible asset and is a broad term that encompasses most intangible assets. Most IP is covered under Section 197. Examples of these Section 197 intangible assets include patents, goodwill, trademarks, and trade and franchise names.

Not all IP is amortized over the 15-year period set by the IRS, however. There are certain exclusions, such as software acquired in a transaction that is readily available for purchase by the general public, subject to a nonexclusive license, and has not been substantially modified. In those cases and select others, the intangibles are amortized under Section 167.

Special Considerations

When a parent company purchases a subsidiary company and pays more than the fair market value (FMV) of the subsidiary’s net assets, the amount over fair market value is posted to goodwill (an intangible asset). IP is initially posted as an asset on the firm’s balance sheet when it is purchased.

IP can also be internally generated by a company’s own research and development (R&D) efforts. For instance, a company may win a patent for a newly developed process, which has some value. That value, in turn, increases the value of the company and so must be recorded appropriately.

In either case, the process of amortization allows the company to write off annually a part of the value of that intangible asset according to a defined schedule.

Amortization vs. Depreciation

Assets are used by businesses to generate revenue and produce income. Over a period of time, the costs related to the assets are moved into an expense account as the useful life of the asset dwindles. By expensing the cost of the asset over a period of time, the company is complying with GAAP, which requires the matching of revenue with the expense incurred to generate the revenue.

Tangible assets are expensed using depreciation, and intangible assets are expensed through amortization. Depreciation generally includes a salvage value for the physical asset—the value that the asset can be sold for at the end of its useful life. Amortization doesn’t take into account a salvage value.

Types of Amortization

For accounting (financial statement) purposes, a company can choose from six amortization methods: straight line, declining balance, annuity, bullet, balloon, and negative amortization. There are only four depreciation methods that can be used for accounting purposes: straight line, declining balance, sum-of-the-years’ digits, and units of production.

For tax purposes, there are two options for amortization of intangibles that the IRS allows. These are straight line and the income forecast method. The income forecast method can be used instead of the straight-line method if the asset is: motion picture films, videotapes, sound recordings, copyrights, books, or patents. For depreciation of physical assets, the IRS only allows the Modified Accelerated Cost Recovery System (MACRS).

Example of Amortization

Assume, for example, that a construction company buys a $32,000 truck to contractor work, and that the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the $32,000 cost basis minus the expected salvage value—in this case, $4,000—divided by eight years. The annual deprecation for the truck would be $3,500 per year, or ($32,000 – $4,000) ÷ 8.

On the other hand, assume that a corporation pays $300,000 for a patent that allows the firm exclusive rights over the intellectual property for 30 years. The firm’s accounting department posts a $10,000 amortization expense each year for 30 years.

Both the truck and the patent are used to generate revenue and profit over a particular number of years. Since the truck is a physical asset, depreciation is used, and since the rights are intangible, amortization is used.

What Is an Acquisition Cost?

An acquisition cost, also referred to as the cost of acquisition, is the total cost that a company recognizes on its books for property or equipment after adjusting for discounts, incentives, closing costs and other necessary expenditures, but before sales taxes. An acquisition cost may also entail the amount needed to take over another firm or purchase an existing business unit from another company. Additionally, an acquisition cost can describe the costs incurred by a business in relation to the efforts involved in acquiring a new customer.

Understanding Acquisition Costs

Acquisition costs provide a reflection of the true amount paid for fixed assets before sales tax is applied, for expenses related to the acquisition of a new customer, or for the takeover of other firms. Acquisition costs are useful because they recognize a more realistic cost on a company’s financial statements than using other measures. For instance, the acquisition cost of property, plant, and equipment (PP&E) recognizes any discounts or additional costs that the company will experience and is often referred to as the original book value of the asset in question.

Acquisition Costs for Fixed Assets

Besides the price paid for the asset itself, additional costs may also be considered part of acquisition when these costs are directly tied to the acquisition process. For example, if the asset in question requires legal assistance to complete the transaction, legal and regulatory fees are also included. Commissions associated with the purchase may also be included, such as those paid to a real estate agent when dealing with a property transaction, to a staffing company for placing an employee, to a marketing firm for acquiring customers, or to an investment bank for brokering a merger.

With regard to manufacturing or production equipment, any costs associated with bringing the equipment to an operational state may also be included in the cost of acquisition. This includes the cost of shipping & receiving, general installation, mounting, and calibration.

Acquisition Costs for Customers

Customer acquisition costs are those funds that are used to introduce new customers to the company’s products and services in hopes of acquiring the customer’s business. The customer acquisition cost is calculated by dividing total acquisition costs by total new customers over a set period.

Understanding customer acquisition costs is helpful in planning future capital allocations for marketing budgets and sales discounts. Costs traditionally associated with customer acquisition include marketing and advertising, incentives and discounts, the staff associated with those business areas, and other sales staff or contracts with external advertising firms. Incentives may be expressed in various formats, such as buy-one-get-one-free deals, receiving another product free with purchase, upgraded service at no additional cost to the customer, gift cards, or bill credits.

One business sector with a high occurrence of promotions directed at new customers is the wireless and cellular industry. Wireless companies often extend deals to new customers such as increased data packages, additional family phone lines for free, and discounts on the newest cellular phones. The purpose of these offerings is to entice customers to choose their business over their competitors.