Depreciation vs Amortization

Article byWallstreetmojo Team
Edited bySusmita Pathak
Reviewed byDheeraj Vaidya, CFA, FRM

Difference Between Depreciation and Amortization

Depreciation is the reduction in the value of the fixed assets due to normal wear and tear, usage or technological changes, etc. It applies to tangible assets. In contrast, amortization refers to the process under which the cost of different non-physical assets of the company are expensed over a specific period and thus applies only to the company’s intangible assets.

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Assets are the backbone of any business. No business can run without owning an asset, as it generates economic returns and revenue over its life. Therefore, it must be depreciated or amortized in the books of accounts to recognize its true value. Companies use methods like depreciation or amortization to depreciate the asset over its useful life.

Key Takeaways

  1. Depreciation refers to an asset’s gradual wear and tear that reduces its initial value. Amortization, on the other hand, is the general reduction in the value of an intangible asset over its useful life. 
  2. The most basic and essential difference is that depreciation is accounted for tangible assets, whereas intangible assets are recorded using amortization. Depreciation also includes salvage value/scrap value. 
  3. Methods to calculate depreciation are Straight-Line Method, Declining Balance, and Double Declining Balance Method. For amortization, the Bullet and Balloon methods are used. 
  4. Both theories are non-cash expenditures, and businesses must remember the importance of asset management not to lose labor efficiency. 

Depreciation vs. Amortization Comparative Table

DepreciationAmortization
A technique to calculate the reduced value of the tangible asset is known as depreciation.A technique to measure the reduced worth of intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more is known as amortization.
Allocation of the cost principleCost PrincipleCost Principle is an accounting principle that records an asset at the original buying cost, which implies that changes in its market value must not impact its representation in the Balance Sheet. read moreCapitalization of the cost principle
The different methods of depreciation are a straight line, reducing balance, annuity, sum of years, etc.The different methods to calculate the amortization are straight line, reducing balance, annuity, increasing balance, bullet, etc.
Applies over tangible assetsApplies over intangible assets
The governing accounting standard of depreciation is AS-6.The governing accounting standard of amortization is AS-26
Examples of Depreciation asset are Plant Machinery Land Vehicles Office FurnitureExamples of Amortization assets are Patents Trademark Franchise Agreements Cost of issuing bonds to raise capital Organizational costs Goodwill
The cost of depreciation is shown in the Income statementThe cost of amortization is also shown in the income statement.
Non-cash itemNon-cash item

What Is Depreciation?

DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more refers to the expenses of an asset that are fixed and tangible. These are physical assets that are reduced each year due to wear and tear. This amount is chargeable to the income statement.

The properties, including buildings, equipment, tools, machinery, etc. let businesses manufacture and produce goods that they sell to generate revenue. Any damage to these ultimately affects the value of those properties, causing depreciation. For example, in a damaged plant resale, buyers would hardly take interest in buying it unless the sale value is low. This shows how deprecation affects a business premise.

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What Is Amortization?

On the other hand, amortization is the expense of an asset over its useful life. However, amortizationAmortizationAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.read more applies to intangible assets over the life of the asset. Therefore, this amount is also chargeable to the company’s income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more.

Some examples of these intangible assets are copyrights, trademarks, patents, etc. These are to pay for the time until which the assets are useful. The expense related to the maintenance of these assets remains the same throughout the useful life of that property.

Depreciation vs Amortization: Features

The difference between the two asset valuation types in terms of their features are listed below:

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The only similarity in depreciation and amortization is that they are both non-cash chargesNon-cash ChargesNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation.read more.

Depreciation vs. Amortization Infographics

Let’s see the principal differences between depreciation vs. amortization.

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Depreciation vs. Amortization: Methods

Both processes are non-cash expenses but need to be created like a provision as assets have a particular life and need to be replaced if the business does not want to lose its labor productivityLabor ProductivityLabour productivity is a concept used to measure the worker's efficiency as the output value produced by a worker per unit of time. By comparing the individual productivity with average, it can be identified whether a particular worker is underperforming or not.read more. That is why using these two accounting concepts is crucial and paramount. These two are often identical terms and are commonly used interchangeably, but different accounting standards govern them.

A business should realize the importance of these two accounting conceptsAccounting ConceptsAccounting concepts are the principles, assumptions, and conditions that govern accounting's foundation. They ensure that the accounting is done in a way that the financial statements present a true and fair view.read more and how much money should be set aside to purchase an asset in the future. The business assets should always be tested for impairment at least annually, which helps the company know the real market value of the asset.

The impairment of assetsImpairment Of AssetsImpaired Assets are assets on the balance sheet whose carrying value on the books exceeds the market value (recoverable amount), and the loss is recognized on the company's income statement. Asset Impairment is commonly found in Balance Sheet items such as goodwill, long-term assets, inventory, and accounts receivable.read more also helps the business to forecast the cash requirement and at which year the probable cash outflow should occur.

#1 – Depreciation

  1. Straight-line methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more – The same depreciation expense is charged in the income statement over the asset’s useful life. Under this method, the profit over the year will be the same if considered for depreciation.
  2. Declining Balance MethodDeclining Balance MethodIn declining balance method of depreciation or reducing balance method, assets are depreciated at a higher rate in the initial years than in the subsequent years. A constant depreciation rate is applied to an asset’s book value each year, heading towards accelerated depreciation.read more – Under this depreciation method, the depreciation amount is charged in the income statement in the closing balance of the previous year of the asset, i.e., Asset value- Depreciation for an earlier year = Closing Balance. Under this depreciation method, the profit for the year will be lesser in the initial years and more in the later years when considered in light of depreciation.
  3. Double Declining Balance method (DDB)Double Declining Balance MethodThe Double Declining Balance Method is one of the accelerated methods used for calculating the depreciation amount to be charged in the company's income statement. It is determined by multiplying the book value of the asset by the straight-line method's rate of depreciation and 2read more – This is the most accelerated method of depreciation that counts twice as much of the asset’s book value each year as an expense compared to the straight-line depreciation. Thus, the formula used here is – 2 * straight-line depreciation percent * book value at the beginning of the period.

#2 – Amortization

  1. Bullet Method– Under this amortization method, the intangible amortization amount is charged to the company’s income statement all at once. This method recognizes the expense all at once. Generally, firms do not adopt this method as it largely affects the numbers of profit and EBIT in that year.
  2. Balloon PaymentsBalloon PaymentsThe balloon payment is a huge sum paid at the end of a loan tenure. Most balloon loans come with a short-term tenure; it could be a commercial loan, mortgage, or fully amortized loan. Also, the final installment is at least double the previous installments.read more– Under this method, the amount deducted at the beginning of the process is less. Still, significant expense is charged to the income statement at the end of the period.

The methods for depreciation are also meant for amortization if the latter is evaluated for loans and advances. In that case, the above methods of amortization schedule of loansAmortization Schedule Of LoansLoan amortization schedule refers to the schedule of repayment of the loan. Every installment comprises of principal amount and interest component till the end of the loan term or up to which full amount of loan is paid off.read more are used.

Frequently Asked Questions (FAQs)

How do depreciation and amortization affect the financial statements of a company?

Depreciation and Amortization affect the equity and balance sheet of the company, respectively. Due to depreciation, the value of a company’s equity gets affected, mostly reducing. On the other hand, due to the yearly amortization of assets, the balance sheet is affected as it reduces the asset side of the statement.

Is software depreciated or amortized?

Software is considered a fixed physical asset for several companies; it is depreciated instead of amortized.

Can goodwill be depreciated or amortized?

Goodwill is the market credibility of a company and, thus, is intangible. Therefore, goodwill will be amortized. Moreover, goodwill can be amortized for over 10 years or less.

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