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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 year over the life of the asset to accurately reflect its use. The expense amounts can then be used as a 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.
Key Takeaways
- Amortization and depreciation are two methods of calculating the value of business assets over time.
- Amortization is the practice of spreading an intangible asset's cost over that asset's useful life.
- Depreciation involves expensing a fixed asset as it's used to reflect its anticipated deterioration.
- Many depreciation methods apply amortization and depreciation but the straight-line method is often the only amortization method used.
- The two accounting approaches also differ in how salvage value is used, whether expensing is accelerated, and how each is shown on the financial statements.
Amortization
Amortization is 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's useful 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 schedule is often used to calculate a series of loan payments consisting of both principal and interest in each payment like a mortgage. The concept is somewhat similar. Amortization is the reduction in the carrying value of the balance because a loan is an intangible item.
The term amortization is used in both accounting and lending with different definitions and uses.
Depreciation
Depreciation is the expensing of a fixed asset over its useful 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.
Tangible assets may have some value when the business no longer has a use for them. Depreciation is therefore calculated by subtracting the asset's salvage value or resale value 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 useful life 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 some fixed assets can be done on an accelerated basis. Merriam-Webster provides some accelerate synonyms that include "quickened" and "hastened." A larger portion of the asset's value is expensed in the early years of the asset's life. Vehicles are typically depreciated on an accelerated basis.
"Depreciate" is defined as diminishing in value over time.
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.
| Amortization vs Depreciation: Key Differences | |
|---|---|
| Amortization | Depreciation |
| Applies only to intangible assets | Applies only to physical assets |
| Philosophically spreads an asset's cost | Philosophically reduces an asset's value |
| Generally is only done using the straight-line method | Has many methods a company may choose from |
| Often results in the same amount recorded each year | May result in accelerated, inconsistent amounts recorded each year |
| Doesn't incorporate salvage value when determining amortization base | May incorporate salvage value when determining depreciation base |
| May not always use contra assets | Always uses contra assets |
Special Considerations
Depletion
Depletion is another way in which the cost of business assets can be established in certain cases but it's relevant only to the valuation of natural resources. An oil well has a finite life before all the oil is pumped out. The oil well's setup costs can therefore be spread out over the predicted life of the well.
Percentage depletion and cost depletion are the two basic forms of depletion allowance. The percentage depletion method allows a business to assign a fixed percentage of depletion to the gross income received from extracting natural resources. The cost depletion method takes the basis of the property into account as well as the total recoverable reserves and the number of units sold.
Cash Flow
One of the primary similarities between depreciation, amortization, and depletion is the recognition of an expense without the associated cash flow. Depreciation and amortization are both very misleading expenses for this reason. They may be omitted from certain reports to better clarify operating needs.
A company must often treat depreciation and amortization as non-cash transactions when preparing its statement of cash flow. A company may find it more difficult to plan for capital expenditures that may require upfront capital without this level of consideration.
Example of Amortization vs. Depreciation
Amazon (AMZN) included full-year comparative financial statements accompanied by financial statement notes as part of its 2021 annual report. As shown on the company's statement of cash flow, Amazon aggregated depreciation and amortization, reporting $34,296 of combined activity.
Amazon explained how it approaches depreciation and amortization as is standard in financial statement disclosures. The company uses the straight-line method for both but it uses a wide range of useful lives depending on the underlying asset.
Amazon reported $238.8 billion of gross property and equipment at the end of 2021. Only $78.5 billion of total accumulated depreciation and amortization was recognized, indicating that roughly one-third of the company's fixed assets were depreciated. Land was also included in this section, which is non-depreciable. Amazon reported $160.3 billion of net property and equipment at the end of the year.
Amazon provided additional details regarding its intangible assets. It classified these as either finite-lived or in-process used in research and development (R&D). Most of the company's intangible assets were finite-lived with most of them being either marketing-related or contract-based. The company had almost $7 billion of intangible assets at the end of 2021 although it had accumulated amortization of over $1.8 billion.
What Is an Example of Amortization?
A company may amortize the cost of a patent over its useful life. Say the company owns the exclusive rights over the patent for 10 years and the patent isn't to renew at the end of the period. The company may amortize the cost of the patent for the decade, recognizing 10% of the expenses each year. The carrying value of the trademark decreases through amortization.
What Is an Example of Depreciation?
The sum-of-the-years digits method is an example of depreciation in which a tangible asset such as a vehicle undergoes an accelerated method of depreciation. A company recognizes a heavier portion of depreciation expense during the earlier years of an asset's life under this method. More expense should be expensed during this time because newer assets are more efficient and more in use than older assets in theory.
Why Do We Amortize Instead of Depreciate a Loan?
Loans are amortized because they're intangible. A loan doesn't deteriorate in value or become worn down through use as physical assets do. Loans are also amortized because the original asset value holds little value in consideration for a financial statement. The notes may contain the payment history but a company must only record its current level of debt, not the historical value less a contra asset.
How Do I Know Whether to Amortize or Depreciate an Asset?
GAAP provides accounting guidance on how to treat types of assets. These accounting rules stipulate that physical, tangible assets are to be depreciated and intangible assets are amortized, although there are exceptions for non-depreciable assets.
Is It Better to Amortize or Depreciate an Asset?
It's neither better nor worse to amortize or depreciate an asset. Accounting guidance determines whether it's correct to amortize or depreciate. Both options spread the cost of an asset over its useful life and a company doesn't gain any financial advantage through one rather than the other.
The Bottom Line
Two common techniques are used to reflect the benefit of an asset and its associated costs over some time. Both depreciation and amortization reduce the carrying value of assets and recognize expenses as assets are used over time. Depreciation is used for physical assets and amortization is used for intangible assets. They vary in the methods available, acceleration options, how salvage value is used, and how contra accounts are used.
Correction—Jan. 20, 2022: An earlier version of this article listed land as an asset that could be depreciated. Land cannot be depreciated, according to the IRS.