Amortization vs. Depreciation: What’s the Difference?

To manage the company’s assets effectively, a grasp on the difference between depreciation and amortization is a must.

Understanding and applying proper depreciation and amortization practices leads to informed decision-making, diligent tracking and accurate financial records.

This fosters trust among the stakeholders and enhances your goodwill. By embracing such practices, businesses commit to long-term success and financial integrity. 

Let’s dive deeper to understand the difference between depreciation and amortization.

What is Depreciation?

With Depreciation, you get to allocate the cost of tangible assets like machinery, vehicles, buildings and equipment over their lives. The decrease in the value of tangible assets due to physical deterioration is termed Depreciation. 

Depreciation calculation in asset management products is important for various reasons like financial reporting, asset valuation, tax purposes, budgeting and planning, compliance and auditing, and more.

To maintain reliable and transparent financial records for businesses, accurate tracking and reporting of depreciation is pivotal. 

Recommended Read: 7 Company Valuation Methods

Different Methods to Calculate Depreciation

One of the major differences between depreciation and amortization is the method of calculation. Amortization is generally calculated with a single straight-line method whereas for calculating depreciation, there are three common ways:

Straight-line Method

The simplest method that spreads the cost of the asset over its useful life. 

Depreciation = (Cost of Asset – Salvage Value)/Useful Life

Double-Declining Balance Method

The common variations in this method are sum-of-the year’s digits and double-declining balance methods as it calculates the higher depreciation expenses in the initial years of an asset’s life and lower expenses of the later years. 

2*Basic Depreciation rate*Book value

Recommended Read: How to Categorize Expenses

Unit-of-Production Method

Depreciation is calculated based on the actual production output or usage of the asset. 

Per Unit Depreciation = (Asset Cost – Residual Value) / Useful Life in Units of Production

Total Depreciation Expense = Per Unit Depreciation x Units Produced

What is Amortization?

Amortization reflects the value of intangible assets over the company’s financial statements complying with the accounting standards and regulations.

It is the process of spreading over the cost of an intangible asset over its useful life where the initial cost is allocated systematically or the value of the intangible asset to expense over a specific duration.

To name a few, patents, trademarks, franchises, goodwill, and licenses are intangible assets.

In brief, amortization improves the accuracy of financial reporting, facilitates asset valuation, ensures compliance with accounting standards, and provides tax benefits for businesses that hold intangible assets.

With some clarity on amortization, the difference between depreciation and amortization becomes easier to understand. 

Calculating Amortization

The straight-line method is used to calculate the amortization of intangible assets. Companies spread the cost of their assets in even distribution over their useful life. 

Amortization Expense = (Cost of Asset – Salvage Value) / Useful Life

Above:

• The cost of the asset is the initial purchase price of the asset
• The estimated residual value at the end of its useful life is the salvage value 
• Useful life is the estimated duration over which the asset provides benefits or generates revenue

Application of Depreciation and Amortization

Let’s explore the various applications of depreciation and amortization across multiple sectors and industries.

The economic usefulness of the tangible assets and decision-making regarding asset repair, replacement or disposal happens with depreciation while amortization helps in assessing the value and lifespan of intangible assets for guiding strategic decisions for utilization and acquisition. 

Tax Planning

With depreciation and amortization, businesses can claim tax deductions which ultimately lowers their tax liability resulting in significant tax savings. 

Investor Relations

To figure a company’s financial performance and health, investors and stakeholders rely on amortization and depreciation as these metrics provide insights into the company’s asset management practices, long-term sustainability and capital expenditure strategies. 

Financial Reporting

For accurately reporting the value of assets on financial statements and depicting the true and fair view of the company’s financial position, financial reporting is made easier with the help of depreciation and amortization. 

Recommended Read: The Best Way To Calculate Financial Metrics

Loan Repayment

Commonly used in loan mortgages and other types of loans, it ensures that borrowers repay the principal and interest amount in regular installments. Amortization is helpful in loan repayment schedules.

Valuation

Both depreciation and amortization are crucial components in asset valuation models and financial ratios like ROA and EBITDA as they help in accessing the true value and profitability of a company’s assets.

On the whole, amortization and depreciation play integral roles in financial management, decision-making, accounting practices and processes for all business sizes and industries. 

Recommended Read: Operating Income vs EBITDA – What’s the Difference?

Difference between Depreciation and Amortization 

Below is a tabular format to help you easily understand the difference between depreciation and amortization:

Depreciation v/s Amortization: Key differences

With the above simple format, the differences between depreciation and amortization seem pretty clear. Isn’t it?

Benefits of Depreciation and Amortization

Although depreciation and amortization serve different types of assets, both play a crucial role in tax planning, financial reporting, and business decision-making. Below is a tabular representation of their benefits

Examples of Depreciation and Amortization

Given below are hypothetical scenarios to understand the difference between amortization and depreciation with example

Example of Depreciation

A company buys machinery for USD 100,000 which has an expected life of 10 years. Each year, the machinery loses its value so the company will depreciate it. If you follow the straight-line depreciation method, the expense would be (10,000/10) USD 10,000 each year for 10 years which reflects the decreasing value of machinery.

Example of Amortization

A company acquires a patent of USD 50,000 with a legal life of 20 years. The economic usefulness of the patent is estimated to be only 10 years. So, the company amortizes the patent over its economic life.

Using the straight-line method, the company’s expense would be (50,000/10) USD 5,000 each year for 10 years. This reflects the gradual consumption of the patent’s value over its useful life.

Frequently Asked Questions

How to Know Whether to Amortize or Depreciate an Asset?

Whether you should depreciate or amortize an asset depends on the nature of the asset:

For Intangible Assets: Like Patents, Copyrights, Trademarks, and Goodwill, the costs are spread out over their useful life as they don’t have any physical form or are consumer or expire over time. 

For Tangible Assets: These are the physical assets like machinery, vehicles, buildings, and equipment that are usually depreciated as they lose their value over time due to wear and tear, obsolescence or simply aging. The costs are allocated as per their useful life.

Is It Better to Amortize or Depreciate an Asset?

When you understand the difference between depreciation and amortization, it becomes a cakewalk to know whether to depreciate or amortize an asset. Consider the type of asset, if it’s intangible, amortize it, if it’s tangible, depreciate it. 

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

Amortization of a loan represents the gradual repayment of the principal along with the interest over a specific period. On the other hand, depreciation is about the gradual decrease in the value of assets over time. 

Since a loan isn’t an asset, we cannot depreciate it. Amortization reflects the reduction of the loan balances when payments are made to ensure proper accounting during the repayment process. With this, the difference between depreciation and amortization becomes crystal clear.

Conclusion

Knowing when an asset should be depreciated or amortized might seem like a scary decision initially. But, understanding the difference between amortization and depreciation can tame these monsters and make them a little less frightening.

With CrossVal’s advanced financial models, you can gauge deeper insights into all the financial terms that are unclear to you. It’s time to empower your company’s financial strategy and performance with CrossVal!

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