In financial accounting, the depreciation mechanism typically spreads the cost of a long-lived asset over its entire service life. Assets which have a shorter life, such as computers, may be depreciated over a very short period. In most countries, tax accounting for depreciation is subject to rules dictated by the tax authorities and will typically be different from those used in financial accounting.
An example might help. Nowadays, a personal computer will be obsolete and be replaced after about three years. Financial accounting would dictate that the computer be depreciated over a 3-year period. However, the tax authorities may define a personal computer as office equipment and stipulate that it be depreciated over a 10-year period. If the computer was originally purchased for 900, the financial accountant would want to write off 300 per year against profits*, whereas the tax authorities may stipulate that only 90 may be written off against profits each year. Obviously the financial accounting approach would result in lower taxes in the first three years but the tax authorities would find this unacceptable.
Conversely. a company may purchase a piece of equipment which has a life-span of 30 years and financial accounting would dictate that it be depreciated over a 30-year period. However, the tax authorities may allow the equipment to be depreciated over a 10-year period and prudent tax accounting would suggest that a 10-year depreciation period be used to avail of the tax benefits as early as possible.
It can be seen from this that accounting can serve different, and sometimes conflicting, purposes. Large companies have the luxury of being able to run parallel accounting systems for financial accounting, cost accounting, and tax accounting. However, for smaller businesses, this is not practical and compromises must be made. In general, small businesses tend to use the depreciation methods specified by the tax authorities.
In dealing with the issues mentioned above, as well as other aspects of corporation taxation, most businesses call on a corporation tax expert for help. The rules of corporation tax accounting are much more complicated than those of financial accounting. If you fail to take full advantage of these rules, you pay more corporation taxes than necessary. Or, if you do not follow the rules, you could pay a sizable penalty.
Nonprofit organizations do not pay corporation taxes unless they also engage in profit-making activities. However, many of them must file financial statements with state agencies. In general, these financial statements are prepared in accordance with the financial accounting rules described in this overview, but the details vary according to the requirements of the individual agencies.
* Straight-line method used for simplicity