What is the difference between book depreciation and tax depreciation?

Generally, the difference involves the "timing" of the depreciation expense on a company's financial statements versus the depreciation expense on the company's income tax return. The depreciation expense in each year will be different, but the total of all of the years' depreciation expense associated with a specific asset will likely add up to the same total—the cost of the asset.

The book depreciation expense is the amount recorded on the "books" and reported on the financial statements. This depreciation is based on the matching principle of accounting. For example, if a machine costs $500,000 and is expected to be used for 10 years and to have no salvage value at the end of the 10 years, the annual depreciation expense might be $50,000 each year. (This assumes the straight-line method and that the machine was acquired on the first day of an accounting year.) Another company purchasing the same machine might believe that the machine will be useful for only 5 years and have $100,000 salvage value. In that case the company will record $80,000 ($400,000 divided by 5 years) each year. The two companies did their best to match the machine's cost to the accounting periods that the machine is being used to earn revenues.

The tax depreciation is recorded on the company's income tax returns and will be based on the Internal Revenue Service's rules. The IRS might specify that the machine is a 7-year machine regardless of a company's situation. The IRS rules also allow a company to accelerate the depreciation expense. Accelerated depreciation means taking more depreciation in the first few years and less depreciation in the later years of the machine'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 will find the accelerated depreciation to be attractive.

The accounting and IRS rules allow a company to use the 10-year straight-line assumption for the books and the 7-year accelerated method for the tax return. This leads some people to say the company is keeping two sets of books. Of course, the company must 1) maintain depreciation records for the book and financial statement depreciation based on the matching principle in accounting, and 2) maintain depreciation records for the tax return based on the IRS rules.

In some situations the IRS allows for the immediate expensing (the entire cost of the asset is deducted from taxable income in the year it is purchased) of assets up to a specific dollar amount. You can learn more about tax depreciation from www.IRS.gov or from a tax adviser.