Distinguishing Between Amortization and Depreciation

Amortization vs. Depreciation: An Overview

When a company acquires an asset with a long useful life, such as a vehicle, goodwill, or a patent, that asset provides ongoing benefits over time. To accurately account for these benefits, the cost of business assets can be expensed gradually over the asset’s life, a process known as amortization or depreciation. These expenses are then used as tax deductions, reducing the business’s tax liability.

Amortization and depreciation are the main methods used to calculate the value of these assets. The key difference lies in the type of asset being expensed, leading to variations in allowed methods, calculation components, and presentation on financial statements.

Amortization

Amortization involves spreading the cost of an intangible asset over its useful life. Intangible assets like patents, trademarks, and copyrights are valued and expensed through amortization. This method typically follows a straight-line approach, expensing the same amount each period, with no consideration for resale or salvage value.

In a separate context, amortization also refers to loan payment calculations, where a series of payments cover both principal and interest over time, diminishing the loan balance.

Depreciation

Depreciation, on the other hand, entails expensing a physical asset’s cost over its useful life. Tangible assets like buildings, equipment, and vehicles are subject to depreciation, which may consider salvage value. Accelerated depreciation methods can also be utilized, especially for assets like vehicles.

The term “depreciate” reflects the decline in value of a tangible asset over time due to use and wear.

Depreciation Methods

Common depreciation methods include Straight-Line, Declining Balance, Double Declining Balance, Sum-of-the-Years’ Digits, and Units of Production. Each method offers a unique approach to calculating depreciation expense based on the asset’s characteristics and expected usage.

Key Differences

Despite their similarities, depreciation and amortization have distinct differences that influence their application in accounting.

Applicability

Depreciation is for physical, tangible assets, while amortization is for intangible assets.

General Philosophy

Depreciation reduces an asset’s value, mirroring its wear and tear over time, while amortization spreads an asset’s cost over a specific period.

Options of Methods

Amortization typically follows the straight-line method, whereas depreciation offers various method options, impacting the timing and amount of expenses recorded.

Timing (Acceleration)

Accelerated depreciation may be employed for tangible assets to account for heavier usage in the initial years, unlike the consistent approach in amortization.

Use of Salvage Value

Salvage value influences asset base calculations differently for depreciation and amortization, as tangibles may have residual value while intangibles do not.

Use of Contra Account

Depreciation entries get posted to accumulated depreciation, a contra account, while amortization may not always involve contra assets directly.

Special Considerations

Depletion

Depletion relates to the allocation of natural resource costs over their operational life. And, it encompasses percentage and cost depletion methods depending on the business’s operations.

Cash Flow

Both depreciation and amortization reflect expenses without corresponding cash outflows, affecting cash flow reporting and planning for future financial needs.

Example of Amortization vs. Depreciation

Amazon’s 2021 annual report showcases the application of both depreciation and amortization, demonstrating their role in financial statement preparation.

Amazon’s detailed reporting on gross property and equipment, and intangible assets with accumulated amortization, provides insight into the treatment of assets over time.

What Is an Example of Amortization?

A patent owned by a company can be amortized over its duration. Allocating the patent’s cost over its lifespan, say 10 years, results in consistent expenses each year, gradually reducing the patent’s value.

What Is an Example of Depreciation?

Utilizing the sum-of-the-years digits method, a company can accelerate depreciation for assets like vehicles, recognizing higher expenses in the initial operational years due to increased usage.

Why Do We Amortize a Loan Instead of Depreciate a Loan?

Loans, being intangible assets, are amortized to allocate costs over time as they do not physically deteriorate, differing from depreciable physical assets.

How Do I Know Whether to Amortize or Depreciate an Asset?

Accounting standards dictate that tangible assets undergo depreciation, while intangible assets are amortized, offering clear guidance on asset treatment based on their nature.

Is It Better to Amortize or Depreciate an Asset?

There is no inherent advantage in choosing between amortization and depreciation, as both methods serve to allocate costs over an asset’s life. The appropriateness of each method depends on the asset type and accounting rules.

The Bottom Line

Depreciation and amortization play crucial roles in accounting for assets, though they vary in applicability, philosophy, method options, timing, use of salvage value, and contra accounts. Understanding these differences is essential for accurate financial reporting and decision-making.