Depreciation:

Depreciation is an accounting concept. It represents the gradual reduction in the value of an asset over its useful life. Businesses record depreciation in their financial statements to match the cost of an asset with the revenue it helps to generate. 

The idea is to spread the asset's cost over the years it is used. Businesses have flexibility in how they calculate depreciation, using methods like straight-line (same amount each year) or reducing balance (a fixed percentage of the remaining value). 

However, depreciation is not usually deductible for tax purposes — it’s mainly for internal accounting and reporting to stakeholders. 

Capital Allowance: 

Capital allowance is a tax concept. It allows businesses to deduct the cost of certain fixed assets from their taxable income over time, based on rules set by tax authorities. Instead of using depreciation for tax, businesses claim capital allowances.

The rates and methods of claiming capital allowances are determined by the government, and businesses must follow them strictly. This means even if a company depreciates an asset one way in its books, it might have to claim a different amount for tax purposes using capital allowance rules. 

Example: 

A business buys a machine for $10,000. 

1-Let's look at Depreciation (Accounting Purpose): 

The business decides the machine will last 5 years, and uses straight-line depreciation. So each year, it records: $10,000 ÷ 5 = $2,000 depreciation expense. This $2,000 is shown in the business’s profit and loss statement to reflect the machine losing value over time. 

2-Now Capital Allowance (Tax Purpose): Let’s say the tax authority allows a 25% capital allowance on a reducing balance basis. 

The business can claim the following on its tax return: Year 1: 25% of $10,000 = $2,500; Year 2: 25% of the remaining $7,500 = $1,875; Year 3: 25% of $5,625 = $1,406.25, and so on. 

These amounts are deducted from taxable income, helping reduce the tax the business pays. 

Key Point: Depreciation helps show the asset’s cost over time in the business's financial records. 

Capital allowance is what the business can claim for tax relief under the tax rules.