Accounting depreciation vs tax depreciation

Accounting depreciation

Accounting depreciation is the use and tear and wears of tangible assets allocated by the company over the useful life of assets generally governed by corporate laws and accounting standards.

The recognition of accounting depreciation is driven by accounting principles and standards such as US GAAP or IFRS or the country’s financial reporting standard.

Depreciation is a non-cash item and does not represent actual cash movements. Despite being a non-cash item, it appears on the income statement and ultimately in balance sheet getting accumulated to compute written down value of the asset.

So, this non-cash item is ought to be reported by the company. Accounting depreciation is also popularly called book depreciation.

Accounting depreciation is computed using different methods such as:

  1. Straight-line method
  2. Double declining method
  3. Physical units’ method of production and so on.

The most popular method is the straight-line method of depreciation. It distributes depreciation equally over all the periods of asset’s useful lives.

Other methods are accelerated methods allowing for higher depreciation in the earlier years and lower in the subsequent years.

For example, the double-declining method allows for twice the rate of straight-line depreciation in the earlier years.

Example of accounting depreciation

Majestic Inc purchases equipment worth $100,000 with a salvage value of $10,000 and a useful life of 10 years.

In this case, the straight-line method of depreciation is used meaning equal depreciation over the useful life of assets.

Depreciation = (purchase price- salvage)/Useful life = (100,000-10,000)/10 = $ 9000 per year

Tax depreciation

Tax depreciation is depreciation computed as per tax laws and to be reported on the tax return. It is subject to a tax deduction as per jurisdiction. BY deducting depreciation, tax authorities allow individuals and businesses to reduce taxable income.

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However, the taxpayer cannot claim depreciation for all the assets. The conditions are specified in tax laws in order to be eligible for depreciation.

The regulations are country-specific and if countries have several tax jurisdictions like the US, it can be jurisdiction-specific.

The tax laws publish specifications of assets’ class, the period in which they are placed to use and the applicable depreciation allowed for such assets.

In the United States, the Internal Revenue Service is handed the responsibility to publish materials on depreciation.

Example of tax depreciation

Majestic Inc purchases equipment worth $100,000 with a salvage value of $10,000 and a useful life of 10 years.

Now, tax depreciation is as per IRS. IRS may require the equipment to be depreciated over the 7-year property as an accelerated method.

This will result in higher depreciation in the earlier years. The rate keeps changing with conditions. For example, if the equipment is placed in the third quarter of the year, there will be a separate rate for such equipment.

In a nutshell, following are differences between accounting and tax depreciation can be summarized as under:

Accounting depreciationTax depreciation
Depreciation is prepared as per accounting purposes and complies company lawsDepreciation is prepared to comply with tax laws.
The company has a choice in depreciation methods, rates, and useful life.The company has to use the depreciation rate and method as per tax law.
It is based on accounting principles, governed by accounting principles and accounting board.It is governed by tax authorities (IRS in US)