The value of a particular purchase keeps reducing daily for many reasons. What remains constant is value reduction.
Businesses calculate it meticulously as they are also the prime part of the industry functionality. The value reduction of a particular asset is categorized into two types; Depreciation and Amortization.
- Depreciation is allocating the cost of a tangible asset over its useful life. At the same time, amortization allocates an intangible asset’s cost over its useful life.
- Depreciation applies to physical assets such as buildings, vehicles, and machinery, while amortization applies to intangible assets such as patents, copyrights, and licenses.
- Both depreciation and amortization are accounting methods used to allocate costs and reduce taxable income, but they apply to different types of assets.
Depreciation vs Amortization
Depreciation accounts for the decline in the value of tangible assets, such as machinery, equipment, and buildings, due to wear and tear or obsolescence. The asset’s cost is spread out over its useful life and recorded as a series of expenses on the company’s financial statements. Amortization accounts for the decline in the value of intangible assets, such as patents, copyrights, and trademarks. Similar to depreciation, the intangible asset’s cost is spread out over its useful life and recorded as a series of expenses on the financial statements.
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|Parameter of Comparison||Depreciation||Amortization|
|Meaning/Definition||It is the reduction of the cost of tangible assets over their lifespan, which is proportionate to the asset usage in a specific year.||It is the reduction of the cost of intangible assets over a lifespan.|
|Applicable to||It applies to tangible assets like Machines, Equipment, Furniture, and buildings.||It applies to intangible assets like patents, licenses, copyright, and agreements.|
|Implementation method||Depreciation can be done using the straight-line method (SLM) or accelerated depreciation method.||Amortization can be done using the Straight Line Method.|
|Salvage Value||Depreciation has salvage value for the items which have their costs reduced.||Amortization does not have any salvage value to it. It has to be remade entirely at a new cost.|
|Expense and Benefits||Depreciation can be used for taxation purposes. However, rapid depreciation can be highlighted as a higher expense in the initial years of service.||Amortization also helps in taxation purposes and can never be shown higher expense in future years.|
What is Depreciation?
Depreciation is the reduction of the cost of the tangible assets available in the company over its lifespan, which is proportionate to the usage of the same asset in a specific year. Depreciation applies to assets like buildings, machines, equipment, and furniture.
Depreciation can be used as a straight-line method or accelerated depreciation method. Accelerated depreciation is used to show higher expenses in the initial years of the erection of a machine, building, or equipment.
It represents the amount of assets’ value used every year. The depreciated assets earn revenue, and a part of the revenue is allocated as a cost to maintain the asset to produce revenue the following year.
The companies can very well take tax reductions on depreciating items. As such, that will not come under taxable income too.
It is also widely understood that the depreciating costs must be widely spread over some time for taxation purposes. The rules are strict when it comes to tax reductions.
An asset that is depreciating has its own cost over some time. The sum of all depreciation in the asset’s life span is called accumulated depreciation.
What is Amortization?
Amortization is the reduction of costs for intangible items over their life span. Amortization applies to patents, licenses, rental agreements, and copyrights.
Amortization refers to two things, one is clearing the debts through strict instalments, and the other is the spreading of expenses which is related to the intangible assets over some time. The period shall generally be the entire lifespan of the intangible asset.
Amortization can be used for taxation purposes too. It can be used as the Straight-line method.
The amortization is a cost tied up with the intangible asset, which must be adjusted with the revenue generated by the tangible assets. The value of intangible assets keep reducing every year.
Amortization is majorly connected with the debt that the company has. The more significant percentage of amortization goes towards the principal amount in the loan; the rest is the interest being paid.
Amortization assets cannot benefit from the salvage value as they cannot be resold.
Amortization is considered an expense to the company; in the balance sheets, the record of amortization shall be done as a portion of the cost, not the entire cost. This is done in each accounting period of a financial year.
Main Differences Between Depreciation and Amortization
- Depreciation is the reduction of cost on the tangible asset over its lifespan, which is proportionate to the usage of the asset in a specific year, while amortization is the reduction of the cost of the intangible assets over a lifespan.
- Depreciation applies to tangible assets like furniture, equipment, building, and machinery, while amortization applies to licenses, patents, copyrights, and trademarks.
- Depreciation can be used as a Straight-Line or accelerated depreciation method, whereas AMortization can only be a straight-line method.
- Depreciation has the asset’s salvage value as it can be resold, while amortization does not have the benefit of salvage value.
- There are taxation benefits for both depreciation and amortization. However, depreciation has higher benefits as higher expenses can be shown through accelerated depreciation in the initial years of service, whereas no such benefit is available for amortization.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.