Both depreciation and amortization are ways of expensing the cost of a business asset over its useful life period. When a company acquires a business asset, the complete cost of acquisition of the asset is not expensed at once, but proportionately based on the time period of their usage.
In essence, both depreciation and amortization mean the same thing. While depreciation refers to the proportionate reduction in the cost of fixed assets or tangible assets over its lifespan. Fixed assets or tangible assets could include things such as a plant, machinery, tools, equipment, etc. Amortization is the same as depreciation except that it is done for Intangible assets like license costs, patents, trademarks, etc.
In pure accounting terms, depreciation can be understood as the systematic reduction in the acquisition cost of a fixed asset until the value of the asset becomes zero or equivalent to salvage value.
Examples of fixed assets include machinery, equipment, tools, etc. By and large, anything which has wear and tear and whose value will decrease over a period of time. Land, though a fixed asset is an exception because land’s value generally appreciates over time and it hardly has any impact of wear and tear.
Process of Calculating Depreciation
Depreciation can be calculated in two ways:
- Straight-line depreciation method
- Accelerated depreciation method
Straight-line Depreciation is calculated as below:
- Deducting the salvage value from the original value of the asset
- The difference is then spread evenly over the useful life of the asset.
- The Depreciated amount hence serves as a tax deduction for the company until the useful life of the asset has expired.
A company purchases a machine for $10000, its salvage value is $2000. The useful life span of the machine is 8 years.
Hence the annual depreciation expense is ($10000-$2000)/8 which is equal to $1000.
In the case of accelerated depreciation, larger depreciation value is calculated at the beginning which gradually decreases over time.
Like depreciation, amortization means the spreading up of the acquisition cost over its expected period of use. The only difference is that in this case, the asset is not a tangible asset, but an intangible one. Examples of intangible assets include things like software licenses, patents, trademarks, etc.
For example, A company bought a tool license for $10000. Its useful life is 8 years. So, in that case, every year $1250 ($10000/8) will be amortized as an expense.
Please note that in case of amortization, only a straight-line method is applicable.
The implication of Depreciation and Amortization
Both depreciation and amortization can be recognized as an expense in the profit and loss statement of the company to reduce tax liability.
The journal entry for both depreciation and amortization is as below:
- Depreciation/amortization expense: debit
- Accumulated depreciation/amortization: credit
Key differences between the two
While Depreciation is related to tangible assets, amortization is related to intangible assets.
- Depreciation involves a salvage value, amortization does not involve a salvage value.
- Depreciation can be calculated by the straight line or accelerated method, amortization is only calculated using the straight-line method.
It is interesting and yet important to note that both amortization and depreciation are just accounting figures and do not involve any cash outflow per se. As mentioned above, depreciation and amortization expense is mentioned under the non-cash section of the Income statement (or profit and loss statement) while the accumulated depreciation/amortization is mentioned in the balance sheet.
It is extremely important to clearly understand these two concepts because any deviation from the financial standards on this can lead to serious regulatory concerns.Sign up in minutes
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