tax vs book depreciation

When a business buys a delivery van, it does not treat the whole cost as an expense the day it pays. Instead it spreads the cost over the years the van is useful — that spreading is depreciation. The twist is that the company spreads the same van two ways at once: one schedule for its financial statements and a different, usually faster, schedule for its tax return.

Book depreciation is the depreciation a company records in its accounting books, chosen to fairly reflect how the asset is used up over its useful life — often straight-line, an equal amount each year. Tax depreciation is the depreciation the tax law lets a company deduct, and tax systems frequently allow accelerated methods that load more of the deduction into the early years (to encourage investment). Imagine a 50,000 van written off straight-line over five years for the books — 10,000 a year — while tax rules permit 20,000 in year one. In year one, tax depreciation (20,000) exceeds book depreciation (10,000) by 10,000, lowering taxable income relative to book income. In later years the tax deduction is smaller and the gap reverses; over the van's life both methods total the same 50,000.

This is the most common and important temporary difference in practice. Because tax depreciation usually runs ahead early, the company pays less tax in early years and records a deferred tax liability for the tax it will pay later when the difference reverses. The total deduction is identical either way — tax depreciation does not save money overall, it just shifts the timing, which is still valuable because paying later is better than paying now.