Financial Depreciation Vs. Tax Depreciation

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Depreciation expense reduces a firm's tax liability.
Depreciation expense reduces a firm's tax liability. (Image: tax forms image by Chad McDermott from <a href='http://www.fotolia.com'>Fotolia.com</a>)

A corporation's fixed, or long-term assets, such as machines and equipment, represent a major portion of its balance sheet. Depreciating an asset means spreading its cost over the span of several years. A firm's top leadership usually requires department heads to establish adequate accounting depreciation procedures to ensure proper and accurate financial data reporting.

Financial Depreciation Defined

Financial depreciation consists of accounting rules that a corporation must follow to depreciate a fixed asset over its "useful" life. A "useful" period, in accounting parlance, indicates the time period in which management expects the asset to be functional. Generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) require a company to depreciate an asset based on a straight-line method (the depreciation expense remains the same each year) or an accelerated method (the depreciation expense varies annually).

Significance

Financial depreciation is pivotal in a firm's financial accounting and reporting mechanisms because fixed assets generally require substantial investments. To illustrate, a company buys a new truck valued at $100,000 and wants to depreciate it over 10 years using a straight-line method. In this case, the annual depreciation expense is $10,000. If the firm prefers an accelerated "50-30-20" depreciation method, the depreciation expense is $50,000 ($100,000 times 50 percent) at the end of the first year, $30,000 at the end of the second year and $20,000 at the end of the third year.

Tax Depreciation Defined

Tax depreciation methods may vary, depending on the industry, the firm's location and size, fiscal compliance requirements and fixed asset amounts. Internal Revenue Service (IRS) rules generally require a company to depreciate an asset over a specific number of years, based on the asset type and its useful life. The IRS provides a tax depreciation table to fiscal accountants in which it instructs on how to abide by fiscal rules. Tax authorities generally prefer accelerated methods of depreciation.

Importance

Tax depreciation methods may affect a corporation's financial data significantly because depreciation expenses may be substantial if fixed asset values are high. For instance, the IRS requires the company to depreciate the truck following the "50-30-20" accelerated depreciation rule. If the company's average income before depreciation expense is $1 million for the next three years, its net income (after deducting depreciation expenses) will be $950,000, $970,000 and $980,000 over the first, second and third year, respectively.

Financial Versus Tax Depreciation

Financial depreciation is distinct from tax depreciation. However, fiscal depreciation rules affect a firm's accounting information and how it reports financial statements. If the company's effective tax rate is 10 percent, it reports a tax expense of $95,000, $97,000 and $98,000 for the next three years, respectively. The firm's accountants may need to record differences between financial tax expense and actual amounts paid to the government as deferred items on the balance sheet.

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