Amortization vs. Depreciation: What's the Difference? (2024)

Amortization vs. Depreciation: An Overview

An asset that's acquired by a company might have a long, useful life. It may provide benefits to the company over time, not just during the period in which it's acquired. Amortization and depreciation are two main methods of calculating the value of these assets whether they're company vehicles, goodwill, corporate headquarters, or patents.

The cost of business assets can be expensed each yearover the life of the asset to accurately reflect its use. The expense amounts can then be used asa tax deduction, reducing the tax liability of the business.

The key difference between amortization and depreciation involves the type of asset being expensed. There are also differences in the methods allowed, including acceleration. Components of the calculations and how they're presented on financial statements also vary.

Amortization

Amortizationis the accounting practice of spreading the cost of an intangible asset over its useful life. Intangible assets aren't physical but they're still assets of value. They can include patents, trademarks, franchise agreements, copyrights, costs of issuing bonds to raise capital, and organizational costs.

Amortization is typically expensed on a straight-line basis. The same amount is expensed in each period over the asset'suseful life. Assets that are expensed using the amortization method typically don't have any resale or salvage value.

The term amortization is used in another unrelated context. An amortization scheduleis often used to calculate a series of loan payments consisting of bothprincipal and interestin each payment like amortgage. The concept is somewhat similar. Amortization is the reduction in the carrying value of the balance because a loan is an intangible item.

Depreciation

Depreciation is the expensing of a fixed asset over itsuseful life. Fixed assets are tangible objects acquired by a business. Some examples of fixed or tangible assets that are commonly depreciated include buildings, equipment, office furniture, vehicles, and machinery.

Tangibleassets may have some value when the business no longer has a use for them. Depreciation is therefore calculated by subtracting the asset's salvage valueor resalevalue from its original cost. The difference is depreciated evenly over the years of its expected life. The depreciated amount expensed each year is a tax deduction for the company until the usefullife of the asset has expired.

A business might buy or build an office building and use it for many years. The business then relocates to a newer, bigger building elsewhere. The original office building may be a bit rundown but it still has value. The cost of the building minus its resale value is spread out over the predicted life of the building with a portion of the cost being expensed in each accounting year.

Depreciation of somefixed assets can be doneon an accelerated basis. Merriam-Webster provides some accelerate synonyms that include "quickened" and "hastened." A larger portionof theasset's valueisexpensed in the early years of the asset'slife.Vehicles are typically depreciated on an accelerated basis.

Depreciation Methods

Companies usually have several options when choosing their depreciation method. The most common methods include:

• Straight-line method: A company depreciates the asset equally over the term of its useful life. The depreciable base is determined by taking the asset's cost and reducing the salvage value. The same amount of depreciation is recorded each year.
• Declining balance: A company depreciates an accelerated amount of depreciation earlier in the asset's useful life by multiplying the current book value of the asset by a fixed depreciation rate that doesn't change over the life of the asset.
• Double-declining balance method: A company depreciates an accelerated amount of depreciation earlier in the asset's useful life by doubling the rate under the straight-line method. This rate is then applied to the current book value.
• Sum-of-the-years digits method: The digits of the asset's useful life are summed. An asset with a useful life would add up to 5+4+3+2+1 = 15 years. A company then depreciates a proportion of costs based on the corresponding digit such as 5/15 for year one and 4/15 for year two.
• Units of production: A company assesses a baseline of anticipated usage. It might buy a company vehicle and intend to drive it 100,000 miles. It assesses its actual use each year such as 17,000 miles driven in year one to determine what proportion to depreciate. It would work out to 17% of the depreciable base in year one in this example.

Key Differences

Now let's take a look at some of the more specific factors that make these two concepts so distinct.

Applicability

Depreciation is only applicable to physical, tangible assets that are subject to having their costs allocated over their useful lives. Amortization is only applicable to intangible assets.

General Philosophy

The term depreciate means to diminish in value over time. Amortize means to gradually write off a cost over a period.

Depreciation is recorded to reflect that an asset is no longer worth the previous carrying cost reflected on the financial statements. Amortization is recorded to allocate costs over a specific period. Both methods appear very similar but they're philosophically different.

Options of Methods

Almost all intangible assets are amortized over their useful life using the straight-line method. The same amount of amortization expense is recognized each year.

A company can choose from several depreciation methods. These options differentiate the amount of depreciation expense a company may recognize in a given year, yielding different net income calculations based on the option chosen.

Acceleration

A company often has the option of accelerating depreciation. More depreciation expense is recognized earlier in an asset's useful life when a company accelerates it. That asset may be used more heavily when it's newest.

Tangible assets can often use the modified accelerated cost recovery system (MACRS). Amortization doesn't often use this practice. The same amount of expense is recognized whether the intangible asset is older or newer.

Use of Salvage Value

The formulas for depreciation and amortization are different because of the use of salvage value. The depreciable base of a tangible asset is reduced by its salvage value. The amortization base of an intangible asset is not. This is often because intangible assets don't have a salvage value. Physical goods such as old cars that can be sold for scrap and outdated buildings that can still be occupied may have residual value.

Use of Contra Account

The credit side of the amortization entry may go directly to the intangible asset account depending on the asset and materiality. Depreciation entries always post to accumulated depreciation, a contra account that reduces the carrying value of capital assets.