In accounting, two related but distinct processes are used when referring to the depletion of assets: amortization and depreciation. Even though the words are often used interchangeably, they refer to the description of which asset’s value is reduced over time. Tangible assets, such as machinery buildings, or automobiles, have depreciation usually occurring. Amortization is used for intangible assets, for example, patents, trademarks, and goodwill.
Amortization refers to the gradual decline in the cost of an intangible asset against its useful life. Intangible assets are those assets that do not have a determined material form. Examples of intangible assets include copyrights, patents, goodwill, trademarks, and franchises. Amortization expenses for the asset costs spread over its useful life to match revenues generated by the asset.
Key Features of Amortization:
Depreciation is an accounting process within the cost-allocating technique in the method. It is a special formal technique to spread out the cost incurred by tangible assets such as vehicles, machines, buildings, and equipment over their useful lives. Depreciation accounts for the diminution of economic wealth attributed to an asset over its lifespan and with the wearing down of the asset.
Key Features of Depreciation:
Depreciation is calculated through several methods, each tailored to different types of assets and their usage. The three most common methods are:
This is the most straightforward method of depreciation. This is a method used in distributing an asset’s cost throughout its life. The straight-line method can be calculated with this formula:
Example: If a machine costs $10,000, has a salvage value of $2,000, and a useful life of 5 years, its annual depreciation would be:
This fixed percentage accelerating depreciation method takes a fixed percentage of the remaining book value of the asset. It forces an increasing depreciation expense in the earlier years of the life cycle of the asset. The formula is:
This method bases depreciation on the asset’s usage, which makes it ideal for equipment where wear and tear depend on the amount of use. The formula is:
Example: A piece of equipment is expected to produce 10,000 units over its lifetime. If it cost $50,000 with a $5,000 salvage value and produced 2,000 units in a year, the depreciation would be:
Amortization and depreciation are both methods of allocating the cost of an asset over its useful life, but they apply to different types of assets and follow distinct processes. Below is a deeper exploration of the key differences between amortization and depreciation, focusing on various accounting and practical aspects:
Criteria | Amortization | Depreciation |
---|---|---|
Type of Asset | Intangible assets (e.g., patents, goodwill) | Tangible assets (e.g., machinery, buildings) |
Methods | Usually straight-line method | Straight-line, declining balance, units of production |
Salvage Value Considered | No | Yes |
Typical Assets | Intellectual property, goodwill | Equipment, buildings, vehicles |
Useful Life Basis | Legal or contractual life | Physically useful life based on wear and tear |
Tax Treatment | Similar to accounting treatment | Often accelerated for tax advantages |
Revaluation | Not commonly revalued unless impaired | May be revalued depending on market value |
Impact on Financial Statements | Reduces intangible asset value, amortization expense on income statement | Reduces tangible asset value, depreciation expense on income statement |
Examples | Patents, copyrights, franchises | Buildings, machinery, vehicles |
Amortization and capitalization are terms of book but are somewhat related yet serve a slightly different purpose. Capitalization is the accounting term where an expenditure is capitalized and taken as an asset rather than an expense where it can be amortized or depreciated over time. Alternatively, the expenditure will be treated as capital investment. Amortization is the process of expensing out the cost of the capitalized asset over its useful life.
For example, if a firm buys a patent, its original cost is capitalized as an asset. The firm then amortizes the cost of the patent over time to represent decreasing value.
Two terms were used to express the difference in how the two are used in intangible versus tangible assets, but it is the application of those differences that makes amortization technically different from depreciation. Amortization would spread cost over time on tangible items like machinery. Amortization, however, would spread cost over time on intangible assets, such as patents. Fundamentally speaking, both amortization and depreciation concepts must be applied to any bookkeeping mechanism that may ensure the matching of costs of tangible and intangible asset costs against revenues generated through those resources.
Amortization is the process of gradually writing off the cost of an intangible asset over its useful life.
Intangible assets such as patents, copyrights, goodwill, and trademarks are amortized over their useful life.
No, depreciation applies to tangible assets. Intangible assets are amortized, not depreciated.
Capitalization records an expenditure as an asset, while amortization spreads the cost of an intangible asset over its useful life.
Depreciation allows companies to spread the cost of tangible assets over their useful life, providing a more accurate reflection of the asset’s value on financial statements.
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