In accounting, depreciation is a method of accounting for the reduction in useful life of tangible assets due to obsolescence, wear and tear. Accounting depreciation and tax depreciation are often different due to the fact that they are calculated according to different procedures and assumptions. The key difference between Accounting Depreciation and Tax Depreciation is that while the accounting depreciation is prepared by the company for accounting purposes based on accounting principles, the tax depreciation is prepared in accordance with Internal Revenue Service’s rules (IRS).
CONTENTS
1. Overview and Key Difference
2. What is Accounting Depreciation
3. What is Tax Depreciation
4. Side by Side Comparison – Accounting Depreciation vs Tax Depreciation
What is Accounting Depreciation?
Accounting depreciation is also known as ‘book depreciation’ and is prepared in accordance with the Matching concept (Revenues and expenses generated should be recognised and recorded for the same accounting period). Book depreciation is also subjected to accounting guidelines introduced by the International Accounting Standards Board (IASB). Accounting standards governing Accounting Depreciation are IAS 4 – Depreciation Accounting and IAS 8 – Accounting Policies, Changes in Accounting Estimates and Errors.
Accounting depreciation is often significantly different to tax depreciation due to two main factors: method of calculation and accounting the useful lifespan of assets.
Methods to Calculate Depreciations
Many methods are available for companies to calculate depreciation. Some widely used ones are,
- Straight-line method
- Reducing balance/ Written down value method
- Sum of digits method
- Units of production method
Lifespan of Assets
Companies are responsible for estimating the useful lifespan of its assets.
E.g. XYZ Ltd purchases a machine for $ 60,000 with an estimated salvage value of $10,000. The economic useful life of the machine is 10 years. This makes the annual depreciation amount (assuming a straight-line method of depreciation) as $ 5,000. ($60,000-$10,000/10).
What is Tax Depreciation?
Tax Depreciation is calculated for the purpose of income tax. The main purpose of this calculation is to reduce taxable income. This is based on the Internal Revenue Service’s rules. Taking the same example, IRS may specify that the useful life of the above machine is 8 years, thus for the purpose of tax depreciation, the calculations should be done for an estimated time period of 8 years.
The IRS rules also allow a company to accelerate the depreciation expense. This means charging more depreciation in the first few years and less depreciation in the later years of the asset’s life. This saves income tax payments in the first few years of the asset’s life but will result in more taxes in the later years. Companies that are profitable find the accelerated depreciation to be more attractive.
Due to this reason, the company has to maintain two types of records for depreciation: one for the financial reporting purpose and the other for income tax purposes.
Furthermore, companies may have different depreciation policies, which tax depreciation is treated differently. For example,
- If the asset is purchased in the middle or towards the end of the year no depreciation will be charged for that year
- Full year’s depreciation will be charged in the year of purchase
- No depreciation will be charged on the year of disposing of the asset
Disposing Fixed Tangible Assets
At the end of the economic useful life, the asset can be disposed for a monetary value. The company will either make a gain or a loss upon disposal, which is recognised in the income statement.
What is the difference between Accounting Depreciation and Tax Depreciation?
Accounting Depreciation vs Tax Depreciation |
|
| Accounting depreciation is prepared for accounting purposes. | Tax depreciation is prepared for income tax purposes. |
| Preparation | |
| It is based on accounting principles and concepts by the IASB. | Based on regulations of the IRS (Internal Revenue Service) |
| Depreciation Method | |
| The company can select one out of many methods. | This often uses accelerated depreciation calculation methods. |
| Accuracy | |
| This is more accurate. | This is calculated under a rigid set of rules thus it is less accurate. |
Reference:
“What is the difference between book depreciation and tax depreciation? | AccountingCoach.” AccountingCoach.com. N.p., n.d. Web. 02 Feb. 2017.
“Forms and Pubs.” Internal Revenue Service. N.p., n.d. Web. 02 Feb. 2017.
“What is tax depreciation? – Questions & Answers – AccountingTools.” Accounting CPE & Books – AccountingTools. N.p., n.d. Web. 02 Feb. 2017.
“Three Differences Between Tax and Book Accounting that Legislators Need to Know.” Tax Foundation. N.p., 17 Jan. 2017. Web. 02 Feb. 2017.
Image Courtesy:
“New Identification Rules For Tax Preparers” by Calita Kabir (CC BY-SA 2.0) via Flickr
“Income tax” by Alan Cleaver (CC BY 2.0) via Flickr