Accounting vs Tax Depreciation
It’s not the same! There are actually differences between accounting and tax depreciation and every company (mainly the internal accounting department or external accounting firm) needs to determine. The financial statements are generated to meet stakeholder needs so it’s important that the selection will do just that.
What is Depreciation?
Also known as Amortization, these terms are often used interchangeably. It is a method of allocating cost of a capital asset over a period of time. Why? If you bought a capital asset, it works well because it’s brand new but over time, there is wear and tear so depreciation is a concept to recognize the reduction in the value of the capital asset.
What makes a Capital Asset a capital asset?
Also known as Fixed Asset or Property, Plant and Equipment (PPE), these terms are often used interchangeably. If you have capital assets, you have ownership over them which is reflected on your company’s balance sheet.
Here are a couple of criteria to recognize capital assets in human language:
The useful or service life exceeds one year (how long can you typically use it for before you can’t?)
You are not planning to resell it as part of your company’s operations (for example, if you own a car dealership and you’re buying cars, it’s not a capital asset because your company is in the business of selling cars)
It’s usually not easy for you to convert it to cash
If you meet these criteria, there’s also a possibility that they are not recognized as a capital asset. Why? Maybe it’s only worth $500 and doesn’t meet a threshold which is typically determined by an accountant. To avoid recognizing all capital assets that meet those criteria above, it’s best to set a threshold. For example, minimum $1,000 each and meets those criteria.
Examples of Capital Assets
Machinery
Equipment
Computers
Building
Land
Furniture
Accounting Depreciation
You may have heard of Generally Accepted Accounting Principles (GAAP) and accounting frameworks like Accounting Standards of Private Enterprises (ASPE) or International Financial Reporting Standards (IFRS). All of them have the goal of allocating the cost of a capital asset over a period of time which is reflected on the financial statements.
Under GAAP, there is something called the matching principle which pretty much says that the revenues and the corresponding costs should be recognized in the same period. If you purchased a capital asset, you are somehow using it to generate revenue. Depreciation is this cost. Think about it this way: you purchased a brand new equipment for $10,000, you used it on a job site for 2 years, now the output is a lot lower. In order to recognize a cost (to satisfy the matching principle), depreciation is recognized.
ASPE and IFRS have pretty much the same depreciation methods.
Depreciation Methods
There are generally 2 depreciation methods:
Straight line – distributes the capital cost evenly over all periods
Declining Balance – distributes the capital cost more at the beginning vs later periods
There are other methods but the above two are the most common. Out of those two above, straight line method is more common because it’s easy.
Example of Straight-Line Method
Capital Cost: $10,000
Salvage Value: $0
Useful Life: 5 years
Here is the formula: (Capital Cost – Salvage Value) / Useful Life
Depreciation = ($10,000-0)/5 years = $2,000 per year
Example of Declining Balance Method
Capital Cost: $10,000
Salvage Value: $0
Depreciation rate: 30%
Here is the formula for year 1: (Capital Cost – Salvage Value) * Depreciation rate
Here is the formula for year 2: Net Book Value * Depreciation rate
Net Book Value = Capital Cost less total depreciation taken (accumulated depreciation)
Depreciation for Year 1: ($10,000-0) * 30% = $3,000
Depreciation for Year 2: ($10,000-$3,000) = 7,000 * 30% = $2,100
Tax Depreciation
This is the method that the Canada Revenue Agency (CRA) determines what you can use as a deduction to taxable income for the use of capital assets. This method is also known as Capital Cost Allowance (CCA). Under this method, the capital assets are separated into different classes and these classes indicate what the CCA rate you can use is. Here is a link to CRA’s website on the CCA classes (CCA classes - Canada.ca)
For example,
A vehicle may fall under class 10 or class 10.1 which has a CCA rate of 30%
A building may fall under class 1 (CCA rate 4%) or Class 3 (CCA rate 5%)
CRA uses something called a Half Year Rule applied to capital assets in the year of purchase and disposition. Essentially, CRA will assumed you purchased the capital asset sometime during the year so you can’t claim a whole year’s worth of CCA. Same thing in the year you dispose of it.
It’s important to note that CCA is not in accordance with GAAP because it doesn’t follow the matching principle and doesn’t follow ASPE or IFRS frameworks.
Example of CCA calculation:
Capital Cost: $10,000
CCA class 17 (CCA rate of 8%)
CCA in Year 1 = Capital Cost * CCA rate * ½ year rule = $10,000 * 8% * ½ = $400
Undepreciated Capital Cost (UCC) = Capital Cost less CCA taken
CCA in Year 2: UCC * CCA rate = $9,600 * 8% = $768
What does this mean? In Year 1, you can claim $400 as a deduction to offset your taxable income. In Year 2, it jumps to $768.
Which one to use for Financial Statements?
You just learned that accounting depreciation is in accordance with GAAP while tax depreciation is not. It should be a no brainer right? Actually, it doesn’t have to be. Either method is a valid choice when it comes to financial statements; it really depends on who the user is, how much of your balance sheet is comprised of capital assets and the value of those capital assets.
If a stakeholder requires a Review or Audit engagement as part of the year end, you will have to follow a framework (ASPE or IFRS) which means it has to be in accordance with GAAP.
If a stakeholder only requires a Compilation engagement (former name is Notice to Reader), then you can use either method if the value of the capital asset isn’t significant.
Quick Accounting Lesson
This is how you account for depreciation on the financial statements. If let’s say you have $1,000 depreciation on equipment, these would be your journal entries:
Dr. Depreciation Expense $1,000
Cr. Accumulated Depreciation-Equipment $1,000
Accumulated depreciation is an account that offsets the original capital asset item. It shows a reduction of value in it. You might be thinking; couldn’t I just put this amount in the original capital asset? Well, it has to be shown separately (either on the financial statements or in the notes section) to provide users with a better understanding.
What happens on the tax side?
Let’s say that you used accounting depreciation in your financial statements. But what happens on the tax side? According to CRA, you cannot deduct depreciation in the calculation of taxable income. Why? It’s not a cost that you pay out, however, CRA does allow you to claim capital cost allowance as seen above.
If you used tax depreciation in your financial statements, it may be the same number that you can deduct.
Depending on the method and rates used for accounting and tax depreciation, the ‘depreciation’ number will be different. Remember what you learned above? CCA is based on classes which has a different rate while accounting depreciation is based on straight-line or declining balance method with different rates.
How to Reconcile Accounting vs Tax Depreciation
Your external accountant may ask you every year if you purchased or disposed any capital assets. This is important due to the half year rule from above.
Here is a quick explanation of how to reconcile both:
You or your external accountant calculates depreciation under both methods (let’s say it comes out to $1,000 per accounting depreciation and $700 per tax depreciation)
Notice the $300 difference?
Unfortunately, you won’t be able to deduct $300 off taxable income (which means you are reporting more income and paying more taxes)
The above also works in the opposite direction.
Do you have to claim CCA?
The quick answer is no since CCA is completely optional. You can claim none, partial or full CCA. If your business is generating income, it would be a good idea to claim CCA in order to reduce the amount of taxes you need to pay. If your business is generating a loss, it would be a good idea not to claim CCA since you cannot claim CCA to increase a business loss.
I Get Asked This Question a Lot
For the finale, here is a question I get asked a lot.
‘The equipment had costed $10,000 and the total depreciation taken is $10,000 or $9999, that leaves a value of $0 or $1, does that mean I can write if off?’
You’ve probably asked this to your accounting team too and no, you can’t just write it off.
There are only 3 situations where you can write it off:
You sold it
It was stolen
You threw it in the garbage and don’t physically have it anymore
Your Turn
In your own organization, which method do you use and did you understand the above? If you’re not sure or have no idea, it’s time to look for a solution that can help you bridge the gap. If you currently don’t have something like this but would be interested in setting something up, make sure to reach out to an accountant.
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