For the company’s financial statements, the economic life of the asset should be used—not the years of useful life required for income tax purposes. In other words, the Internal Revenue Service (IRS) might stipulate that certain equipment is to be depreciated on the income tax return over 7 years. However, the company knows that the equipment will be useful in producing revenues for 10 years. Accounting’s matching principle requires that the company’s financial statements match the equipment’s costs to its revenues over a 10-year period. (This will result in the most accurate measurement of the company’s accounting net income.) However, on the tax return the company must follow the IRS rules and will depreciate the asset over 7 years. Obviously, this will result in two sets of depreciation amounts. (Further, the company’s financial statements can use straight-line depreciation over the 10 years while the income tax return is using an accelerated method of depreciation over the 7 years.)
The difference in each year’s depreciation is referred to as a timing difference. The reason is that over the life of the equipment, the total amount of depreciation expense is likely to be the same. It is just a matter of timing as to when that total amount is reported on the financial statements versus the income tax returns.
