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Even the best business equipment and assets grow old: computers, furniture, the new HVAC system you just installed. Depreciation is an accounting method to record the loss of value due to age and time. You use depreciation in both your regular bookkeeping and your tax accounting, but there are significant differences between book depreciation (financial depreciation) and tax depreciation.
TL;DR (Too Long; Didn't Read)
The difference between book/financial depreciation and tax depreciation is that you can claim depreciation as a tax write-off quicker than you report it in your regular accounting. However, the total amount of depreciation on an asset will be the same in both approaches.
Book Depreciation Methods
When investors or lenders look at your firm's finances, they want to know the value of your assets among other things. Depreciating the book value of older assets assigns them a more realistic value than if you only reported the original purchase price.
For example, suppose your company purchased $30,000 in cutting-edge factory equipment five years ago. After five years, it's no longer as cutting edge, and it's showing wear and tear. Rather than keeping it on the books as a $30,000 asset, you depreciate the purchase price.
Typically, you'd depreciate the same amount each year over the useful life of the equipment. If it's 10 years, you'd depreciate $3,000 each year, recording it in what's called a contra asset account. After five years, you'd have $15,000 in accumulated depreciation on the balance sheet, making the equipment's book value $15,000.
Depreciation and Salvage
Book depreciation methods in the United States follow generally accepted accounting principles, or GAAP. These principles include guidelines for figuring out the useful life of an asset such as computers, vehicles or office furniture. Your depreciation accounting also has to consider whether you can resell an asset for salvage value at the end of its life.
Suppose you buy a computer this year for $2,400. You estimate that its useful life is three years, after which you can resell it for $600. You'd depreciate the computer by $600 a year to bring it down to $600.
If, however, you think the computer has no salvage value, then you depreciate to zero. The depreciation in each of the three years would be $800. If you manage to sell the computer after all, you record the proceeds as a gain.
Book vs. Tax Depreciation
Depreciation is a valuable tax deduction. You can lower your taxable income by claiming depreciation as an expense. Unlike most deductible expenses, though, you don't actually spend any money.
The big difference between book and tax depreciation is that you get to claim tax depreciation quicker. The IRS allows an accelerated depreciation system that lets you take bigger write-offs in the early years. You can even write off some purchases completely the year you make them under the Section 179 deduction rules.
While you can take tax depreciation quicker than book depreciation methods, you can't take more of it. Suppose you buy a used truck for $16,000. You'll depreciate it quicker on your taxes than your accounts, but at the end of its useful life, both methods will depreciate the entire cost of the truck down to zero.
Many U.S. businesses, such as publicly traded corporations, have to make out their financial statements according to GAAP. They have to keep one set of books for their own accounting and another for their taxes to reflect the different rules of accounting depreciation vs. tax depreciation.
Companies that aren't publicly traded can legally use tax accounting for their bookkeeping and their financial statements. That way, they avoid the inconvenience of using both book depreciation methods and tax depreciation. As there are many other differences between GAAP and tax accounting, this approach can have the effect of making your business look less prosperous.
- Accounting Coach: What Is The Difference Between Book Depreciation and Tax Depreciation?
- AccountingTools: Depreciation
- AccountingTools: Salvage Value
- AccountingTools: Tax Depreciation
- Henry+Horne: Common Book-to-Tax Differences, Understanding Your Business
- Marks Paneth: GAAP vs. Tax-Basis Reporting: Choosing the Right Model for Your Business
- Internal Revenue Service (IRS). "Topic No. 704 Depreciation." Accessed July 26, 2020.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com