Difference Between Depreciation and Amortization
Depreciation is the reduction in the value of the fixed assets due to normal wear and tear, normal usage or technological changes, etc and it is applicable on the tangible assets, whereas, amortization refers to the process under which the cost of the different intangible assets of the company, etc are expensed over the specific period of time and is thus applicable only on the intangible assets of the company.
Assets are the backbone of any business. No business can run without owning an asset as the asset generates economic returns and revenue for the business over the life of the asset. But each asset comes with life. It must be depreciated or amortized in the books of accounts to recognize the true value of the asset. Companies use methods like depreciation or amortization to depreciate the asset over its useful life.
Depreciation refers to the expenses of an asset which are fixed and are tangible. The assets are physical assets that are reduced each year due to the wear and tear in them. This amount is chargeable to the income statement.
Amortization, on the other hand, is also the expense of the 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. applies to intangible assets over the life of the asset. This amount is also chargeable to the 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. of the company.
Depreciation vs. Amortization Infographics
Let’s see the top differences between depreciation vs. amortization.
- The critical difference is that the asset that is an expense in depreciation are tangible assetsTangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment. and the assets that are expensed in amortization are intangible
- In amortization there is usually no salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000. is involved whereas in depreciation there is a salvage value most of the cases
- There are various methods used by the business to calculate depreciation however amortization there is the only method which is generally used by companies
- The objective of depreciation is to prorate the cost of the asset over the useful life of the asset, on the other hand, the objective of amortization is to capitalize the cost of the asset over the useful life of the asset
- The only similarity in depreciation vs. 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.
Depreciation vs. Amortization Comparative Table
Methods of Depreciation & Amortization
#1 – Depreciation
- 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. – Under this method, the same amount of depreciation expense is charged in the income statement over the useful life of the asset. Under this method, the profit over the year will be the same if considered from the perspective of depreciation
- 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.– Under this method of depreciation, the depreciation amount is charged in the income statement is charged in the closing balance of the previous year of the asset. I.e., Asset value- depreciation for an earlier year = Closing balance. Under this method of depreciation, the profit for the year will be lesser in the initial years and more in the later years when considered in light of depreciation
- Double Declining Balance methodDouble 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 2 (DDB) – 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 straight-line depreciation. The formula for this method is 2 * straight-line depreciation percent * Book Value at the beginning of the period
#2 – Amortization
- Bullet- Under this method of amortization, the amount of amortization of the intangible is charged to the income statement of the company all at once. This method recognizes the expense all at one go which generally firms does not adopt this method as it affects the numbers of profit and EBIT largely in that year
- Balloon PaymentsBalloon PaymentsWhen part repayment of principal loan such as mortgage loan, commercial loan, etc. is agreed to be made at the end of the loan period or at the maturity where the total outflow is higher than the approx. amount payable on the monthly basis since it does not fully amortize over the term of the loan due to its large amount then it is known as balloon payment.– Under this method, the amount which is deducted at the beginning of the process is less and the end of the period significant expense is charged to the income statement
In most of the cases, the methods used for depreciation are also utilized for amortization unless it is the amortization of 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. are used.
Both processes are a non-cash expense but need to be created like a provision as assets have a particular life and need to be replaced in due course of time if the business does not want to lose their 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..
That is why the use of these two accounting concepts is crucial and paramount. These two are often identical terms and are commonly used interchangeably, but they are both governed by different accounting standards.
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. and how much money should be set aside to purchase an asset in the future. Also, assets of the business should always be tested for impairment at least annually, which helps the business to know the real market value of the asset. The impairment of assets also helps the business to forecast the cash requirement and, at which year, the probable cash outflow should occur.
This article has been a guide to Depreciation vs. Amortization. Here we discuss the top differences between them and their methods along with infographics and comparative table. You may also have a look at the following articles –