Accounting vs. Tax Depreciation: Key Differences Explained

Before we discuss accounting depreciation vs tax depreciation, let us first talk about depreciation itself. Essentially, depreciation is a method of allocating the cost of a tangible asset over several periods of time due to decreases in the fair value of the asset. Note that amortizationAmortizationAmortization refers to the process of paying off a debt through scheduled, pre-determined installments that include principal and interest is a concept similar to depreciation, but it is applied primarily to intangible assets.

Also, the concept of depreciation is applicable to both accounting and tax practices. In accounting, depreciation is referred to as the cost of a tangible assetTangible AssetsTangible assets are assets with a physical form and that hold value. Examples include property, plant, and equipment. Tangible assets are allocated over the periods of its useful life, which is treated as a company’s expense. Depreciation expenses are subtracted from the company’s revenue as a part of the net income calculations.

On the other hand, for tax purposes, depreciation is considered as a tax deduction for the recovery of the costs of assets employed in the company’s operations. Thus, depreciation essentially reduces the taxable incomeTaxable IncomeTaxable income refers to any individual's or business’ compensation that is used to determine tax liability. The total income amount or gross income is used as the basis to calculate how much the individual or organization owes the government for the specific tax period. of a taxpayer. The tax deductions are generally available to both individuals and organizations. The tax rules regarding depreciation deductions may significantly vary among tax jurisdictions. For example, in some countries, the tax regulations allow full deductions of the asset’s cost, while other jurisdictions allow only partial deductions.

What is Accounting Depreciation?

Accounting depreciation (also known as a book depreciation) is the cost of a tangible asset allocated by a company over the useful life of the asset. The recognition of accounting depreciation is driven by accounting standards and principles such as US GAAPGAAPGAAP, Generally Accepted Accounting Principles, is a recognized set of rules and procedures that govern corporate accounting and financial or IFRS. Remember that depreciation is a non-cash item. In other words, depreciation expense does not represent an actual cash flow for a business.

Despite its non-cash nature, depreciation expense still appears on the company’s financial statements. A company records its depreciation expenses on the income statement. Thus, this non-cash item ultimately reduces the net income reported by a company.

In addition, most accounting standards require companies to disclose their accumulated depreciation on the balance sheet. The accumulated depreciation reveals the impact of the depreciation on the value of the company’s fixed assets recorded on the balance sheet.

Accounting depreciation can be calculated in numerous ways. The two most common ways to determine the depreciation are straight-line and accelerated methods.

The straight-line depreciation is the easiest and most frequently used depreciation method. It distributes depreciation expenses equally over all periods of the asset’s useful life.

Conversely, accelerated depreciation methods allow deducting greater depreciation expenses in the earlier periods of the asset’s useful life and smaller depreciation expenses in the subsequent periods. One of the examples of the accelerated depreciation method is the double declining depreciation methodDouble Declining Balance DepreciationThe double declining balance depreciation method is a form of accelerated depreciation that doubles the regular depreciation approach. It is.

What is Tax Depreciation?

Tax depreciation is the depreciation expense listed by a taxpayer on a tax return for a tax period. Tax depreciation is a type of tax deduction that tax rules in a given jurisdiction allow a business or an individual to claim for the loss in the value of tangible assets. By deducting depreciation, tax authorities allow individuals and businesses to reduce the taxable income.

A taxpayer cannot claim depreciation for all assets. Only some assets that meet the specific requirements in the given tax jurisdiction may be eligible for the depreciation claim. Although the requirements generally vary among the tax jurisdictions, the most common criteria for the depreciable assets are:

• The asset is the property owned by a taxpayer.
• A taxpayer uses the asset in the income-generating activities.
• The asset possesses a determinable useful life.
• The asset’s useful life is more than one year.

In some jurisdictions, the tax authorities publish guides with detailed specifications of assets’ classes. The guides may specify the lives for each class of assets and their respective methods of depreciation calculations. For example, the Canada Revenue Agency (CRA) publishes the guide for capital cost allowance (CCA), which includes the classes of different assets with their respective depreciation rates. In the United States, the Internal Revenue Service (IRS) publishes a similar guide on property depreciation.

Additional Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)®Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Depreciation Methods TemplateDepreciation Methods TemplateThis depreciation methods template will show you the calculation of depreciation expenses using four types of commonly use depreciation methods. There are several types of depreciation expense and different formulas for determining the book value of an asset. The most common depreciation methods include: Straight-line
• IFRS vs US GAAPIFRS vs. US GAAPThe IFRS vs US GAAP refers to two accounting standards and principles adhered to by countries in the world in relation to financial reporting
• Deferred Income TaxDeferred Income TaxDeferred income tax is a liability that can be found on a balance sheet. This results from differences in income recognition between tax laws
• Intangible AssetsIntangible AssetsAccording to the IFRS, intangible assets are identifiable, non-monetary assets without physical substance. Like all assets, intangible assets