What Is the Difference Between Depreciation and Amortization?
Depreciation and amortization refer to how a business values its tangible and intangible assets. Both depreciation and amortization appear on the balance sheet of most small businesses.
The major difference between the two terms is that depreciation is used for tangible assets, and amortization is used for intangible assets. Most business owners implement an amortization schedule to their income statement and work in tangible assets to show the depreciation expense of their company's physical assets.
This article will highlight the differences between depreciation and amortization and provide examples of how to calculate both.
What Is Depreciation?
Depreciation refers to how a physical asset loses value over a period of time through continuous usage. Physical assets are depreciable because they have a predictable usage span and generally at least a small resale value. The useful life of the asset may vary widely from business to business or asset to asset, depending on a given company's use or need.
Tangible assets are also called "fixed assets." This is because fixed assets are those you can touch, which are typically only purchased once for protracted use before being replaced and having a salvage value. Tangible assets begin depreciating after the first year of ownership.
Annual depreciation of tangible assets can be factored into a company's bookkeeping on a straight-line basis. This means that the original cost of the asset is prorated in increments across the time frame of its useful life.
A few common examples of tangible or fixed assets for a business include:
- Office furniture
How Do You Calculate Depreciation?
Two simple ways to calculate depreciation are the straight-line method and the declining balance method. The Internal Revenue Service (IRS) recognizes depreciation as a tax deduction, so it's important to choose a method for monitoring depreciation of fixed assets accurately in small business accounting.
The depreciation method companies choose is simply based on what business owners feel will best reflect their company's actual expensing regarding the asset in question.
- Declining balance: This approach is generally reserved for calculating depreciation on fixed assets that are known to become obsolete more rapidly than others. Computers, vehicles, or any other machinery that relies on higher technology fall into this category. The equation for calculating depreciation under a declining balance approach appears as follows:
Declining Balance Depreciation = Current Book Value (CBV)×Depreciation Rate (DR)
- Straight-line: This approach is generally more suitable for fixed assets that experience depreciation more steadily over a protracted period of time. Buildings, furniture and mechanical machinery fall into this category. The equation for calculating depreciation on a straight-line basis appears as follows:
Straight-Line Depreciation = (Asset Cost - Salvage Value) Useful Life of Asset
Imagine that a company purchases a new suite of central computers for $10,000, and these computers have an estimated useful life of five years. Let's assume that these same computers have a salvage value of $4,000. When calculating depreciation under the straight-line method, the annual depreciation on those computers would be $1,200. That's $10,000 minus $4,000 divided by the five years of estimated usefulness.
Using the same example, that company can also choose to incorporate an accelerated depreciation method or "declining balance" approach to expensing the computers. This means that a greater amount of the computers' total value is listed as depreciable during the earliest years of their predicted usage cycle.
What Is Amortization?
Amortization is the spreading of the original cost of an intangible asset across the span of what's predicted to be its useful life. Intangible assets are those that can't be touched and don't possess resale or salvage value. While intangible assets are not depreciable in the same physical manner in which tangible assets are, this type of asset tends to be bound by time constraints or other restrictions that limit its usable life cycle. Small businesses need to calculate amortization because they can get more money back on their tax return for as long as the asset in question is in use.
Amortization takes the original cost of an intangible asset and extends it over the amount of time that the asset is expected to be used. This reduced value of the intangible asset is recorded on the balance sheet each accounting period and reported as a recurring expense on the company's income statement. Most amortization is expensed using a straight-line method in bookkeeping. This means that the same amount is expensed for the intangible asset each accounting period for the life of the asset.
The following list offers examples of intangible assets companies might need to amortize:
- Trademarks and patents
- Organizational costs
- Proprietary process like copyrights
- Cost of issuing bonds to raise capital
- Franchise agreements
Keep in mind that the word "amortization" is also utilized with a completely different meaning in the world of lending. For instance, an amortization schedule that you pay on your company's mortgage for the building that you work from refers to the series of loan payments that you will make on that building over the life of the mortgage. It doesn't refer to your company's intangible assets at all.
How Do You Calculate Amortization of Assets?
Using the straight-line method, a company begins its figures for the recorded value, the residual value, and the useful life of the intangible asset. The recorded value (also known as the "book value") refers to the original cost of obtaining or creating the asset. The residual value is the intangible asset's expected value at the conclusion of its usage life cycle.
Most intangible assets carry a residual value of zero, as most do not have value after the termination point of their full utilization. The useful life of the asset is simply the established period of time in which the company expects to gain economic value from the asset.
The equation for calculating amortization appears as follows:
Let's say that a company obtains a patent (an intangible asset) on one of its products at a total cost of $25,000 (including any subtractions for residual value) and that patent is licensed for 20 years. The company will expense $1,250 for this patent annually and deduct that value from the patent's value on the balance sheet every year. At the end of the 20-year usage life, the patent will have been fully amortized.
What Is the Difference Between Depreciation and Amortization?
There are a few key differences between depreciation and amortization. Both are calculated for tax purposes on IRS Form 4562. The major difference between the two hinges on the type of asset they are utilized for: Depreciation is used to gauge value loss on tangible (or fixed) assets, and amortization is used to measure the cost of an intangible asset across a protracted period of time.
Another place that amortization and depreciation differ is in their generalized methods of accounting. It is much more common for amortization to be factored into a company's balance sheet using a straight-line accounting method, whereas depreciation may use the straight-line basis or the accelerated method. Lastly, amortized assets differ from depreciated assets in that amortized assets tend to have no salvage value or resale value. Depreciated assets generally still carry resale value at the end of their usage life cycle.
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Calculating amortization and depreciation is an important step for small business owners because it allows for a useful tax break and insight into the company's overall value. Keeping up with your company's fixed and intangible assets is easy with Skynova's business software.
With income, expenses, sales tax, and payment tracking, Skynova's accounting software streamlines and clarifies your company's bookkeeping. Check out Skynova today and enjoy peace of mind when it comes to the amortization or depreciation of your small business's assets.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant on questions of how best to account for amortization and depreciation in your business and to ensure your company stays in alignment with accounting standards for your industry.