Buying business assets such as buildings, and computers, or buying another business is a natural aspect of any business. The expense of those items over some time, depending on the useful life of the asset, is depreciation and amortization.
- Depreciation and amortization are the two methods available for companies to accomplish the business process. These methods calculate the value of business assets and expense them over a set time.
- Another benefit for the companies is tax deductions, depreciation, and amortization, helping reduce the company’s tax liability.
Depreciation:
Depreciation is the expense of a fixed asset over a specified time frame or its estimated useful life.
For example, when you buy a truck or a bike for the delivery business, the company determines how long they think the truck or bike will last and then expense it over that period.
Fixed assets are tangible items or things one can physically touch. Some common fixed assets you will see as expenses:
- Equipment or machinery
- Buildings or land
- Vehicles and other similar equipment
How to calculate the depreciation?
Many fixed assets have value beyond their useful lives. Therefore companies calculate the depreciation less the end value, often called salvage.
For example, if you buy a truck for $15,000 and determine at the end of its useful life you could sell it for $1,000, then the company would depreciate the value based on the $14,000.
Company’s tax benefit: The company’s tax benefit is from the depreciation expense each year until the asset’s useful life ends.
What is straight-line: Straight-line is the most common depreciation. It means to expense for a fixed number of years.
For example, if you expense the value of your truck over nine years, you have an expense of $1,000 a year.
Amortization
It is the accounting practice of spreading the cost of an intangible asset over its useful life.
Intangible assets are not physical in nature but they are still assets of value.
For example:
- Patents and Trademarks
- Franchise agreements
- Proprietary or copyright processes
Straight-Line: Amortization is mostly expensed on a straight-line basis. That means that the same amount is expensed in each period over the asset’s useful life.
No salvage value: Assets that are expensed using the amortization method typically don’t have any resale or salvage value.
For example, if the value of a patent is determined in ten years, then the company expenses $10,000 at $1,000 a year.
Similarities between depreciation and amortization
- Both depreciation and amortization are considered non-cash expenses, which means that companies spend no cash in the years they are expensed.
- Depreciation and amortization are accounting measures that help capture the value of fixed and intangible assets on the balance sheet and the expensing of those assets over longer periods. Unlike the intangibles we discussed above, the impact on economics is spread out over time.
- The most common form of depreciation is a straight-line; similar to amortizing an asset, it is also a straight line. Both of these methods determine the asset’s useful life and then divide the purchase price by that useful life to determine the annual expense.
Difference between Depreciation and Amortization
Depreciation and amortization are two terms that you may have heard mentioned before, but may not be entirely sure what they mean. Here’s a quick overview of the differences i.e. amortization vs depreciation:
-Depreciation is the gradual loss of value of an asset over time. This can happen due to wear and tear, normal aging, or use in an improper manner. It is usually recorded as a cost of ownership (COP) item on your balance sheet.
-Amortization refers to the accrual of expense over time associated with an intangible asset such as a patent or copyright. The expense is typically capitalized (i.e., written off) against future income-generating activities similar to depreciation for tangible assets. Amortization occurs over a period of either one or more accounting periods
Learn Accounting with Noon Academy
With Noon Academy, you can learn anytime and anywhere. We make it easy for you to get started with our online e-learning platform in Pakistan.
So what are you waiting for? Download our app now and sign up for an account to start learning today!
Frequently Asked Questions
What are the similarities between amortization and depreciation?
While both depreciation and amortization are methods of allocating the cost of an asset over its useful life, there are some key similarities between the two:
-Both depreciation and amortization are non-cash expenses, meaning that they do not involve any immediate outlay of cash.
-Both depreciation and amortization are used to spread the cost of an asset over its useful life.
-Both depreciation and amortization can be used for tax purposes.
What are the different ways to calculate depreciation?
There are several methods for calculating depreciation, the most common being the straight-line method. Under this method, equal amounts of depreciation are deducted from the asset’s cost each year over the asset’s useful life. The other methods for calculating depreciation are the declining balance method and the sum-of-the-years’-digits method. The declining balance method is a more accelerated way of calculating depreciation than the straight-line method. Under this method, a larger amount of depreciation is deducted in the early years of an asset’s life, with the deduction decreasing in later years. The sum-of-the-years’-digits method is even more accelerated, with larger deductions in the early years and smaller deductions in the later years.
What is an example of amortization?
Amortization is the process of spreading out a loan into a series of fixed payments over time. You’ll often see amortization referred to in the context of mortgages, student loans, and car loans. With amortization, each payment is applied to both the principal (the amount you borrowed) and the interest.