Definition of Book Depreciation
Book depreciation is the amount recorded in the company's general ledger accounts and reported on the company's financial statements. This depreciation is based on the matching principle of accounting.
Example of Book Depreciation
Let's assume that equipment used in a business has a cost of $500,000 and is expected to be used for 10 years. If the company assumes no salvage value at the end of the 10 years, the annual depreciation expense recorded in the general ledger accounts and reported on the financial statements will likely be $50,000 each year. Each year the company is matching $50,000 of the equipment's cost to that year's revenues that are earned because of the equipment.
Definition of Tax Depreciation
Tax depreciation refers to the amounts reported on the company's income tax returns and in the U.S. the tax depreciation is based on the regulations of the Internal Revenue Service (IRS). The tax regulations specify the useful life of assets but also allow for accelerated depreciation or the immediate expensing of certain amounts on some companies' tax returns. There is no regulation that requires the tax depreciation to be the same as the book depreciation in a given year. (However, over the life of an asset, the total depreciation expense for both will be limited to the asset's cost.)
Example of Tax Depreciation
Assuming the company purchases equipment of $500,000 the IRS regulations may require that the equipment be depreciated over 7 years and allows an accelerated method of depreciation. In some years the regulations may allow certain companies to charge the entire equipment's cost to depreciation in the first year. These regulations result in a company having larger depreciation deductions sooner and therefore receiving the income tax savings sooner. You can learn more about tax depreciation from www.IRS.gov or from a tax adviser.
Difference Between Book and Tax Depreciation
Generally, the difference between book depreciation and tax depreciation involves the "timing" of when the cost of an asset will appear as depreciation expense on a company's financial statements versus the depreciation expense on the company's income tax return. Hence, the depreciation expense in each year will likely be different, but the total of all of the years' depreciation expense for an asset will likely add up to the same total.
The difference between book and tax depreciation leads some people to say, "Oh, the company has two sets of books." The fact is the company must 1) maintain depreciation records for the financial statement depreciation that is based on the matching principle, and also 2) maintain depreciation records for the tax return depreciation that is based on the IRS rules.