Depreciation is an accounting technique that spreads a the cost of a company's purchase over several fiscal years. Rather than declaring a large investment or loss for a year, filers can declare parts of it on several statements, maximizing the amount they can deduct from their tax liability. But regular depreciation ignores that inflation reduces the value of money over time. As a result, the purchase's initial cost exceeds the total depreciated values in real dollars. Price-level depreciation adjusts later depreciated values according to inflation, increasing the filer's tax benefits.
1. Estimate the number of years for which you'll use the depreciated item. For example, assume a new vehicle you buy for $40,000 will last 10 years.
2. Divide the item's price by this estimate: $40,000 ÷ 10 = $4,000. This is the item's annual depreciation, not adjusted for price level.
3. Raise the consumer price index, which measures the aggregate rise in the economy's prices, to the number of years before the depreciation that you're calculating. For example, if the average consumer price index is 1.12, and you are calculating the depreciation after five years, then calculate 1.09 to the fifth power to get 1.539.
4. Multiply this factor by the item's annual depreciation: 1.539 × $4,000 = $6,156. This is the item's price-level depreciation for the year.
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