When you’re running a business, everything holds value. From the sophisticated machinery that churns out products to the patents that protect your intellectual property, every asset has a cost and utility attached to it.
However, the associated value doesn’t remain constant as time ticks on. Some tangible assets wear out, while intangible ones may lose their relevance.
So, how do businesses account for this change? Well, by using methodologies like amortization and depreciation. These foundational concepts guide how companies reflect the value of their assets over time.
You’ll often find both the terms being used interchangeably. Though they’re a bit similar in philosophy, there are many points of difference between depreciation and amortization.
Let’s delve deeper into both methodologies and uncover these differences.
What is Amortization?
Essentially, amortization is a way to evaluate the value and cost of intangible assets.
What is an intangible asset? Well, they represent possessions that don’t take physical space but are, nevertheless, of value. That makes putting a price tag on them very difficult, sometimes even nigh impossible. However, their valuation is still important from a business and financial standpoint.
Here are some examples of intangible assets:
- Copyrights
- Trademarks
- Customer Lists
- Franchise agreements
- Organizational costs
- Trade names
- Patents
- Employee Relationship
- Brand Recognition
- Customer Loyalty
Though the values of these resources are subjective, one can amortize them by determining how much money is spent on them.
Amortization of assets isn’t to be confused with amortization in debt. Yes, amortization also refers to debt and loan repayments. When you opt for a mortgage, student, or auto loan, lenders usually define an amortization schedule that outlines the details of debt repayment, specifically the principal interest applicable.
What is Depreciation?
Depreciation is a method to calculate the value of tangible assets of a company over a fixed time interval. This way, businesses can determine the expense of a physical asset in relation to the income it generates.
These assets typically include:
- Real estate
- Equipment
- Office furniture
- Computers and systems
- Tools
- Vehicles
Also, these possessions have some value attached to them at the end of the life cycle, known as the resale or salvage value. This cost is deducted from the original price to determine the final depreciation value.
What Is the Difference Between Depreciation and Amortization?
Although both methods pertain to the valuation of assets, both present certain differences. Here are all of them.
1. Nature of an Asset
The most pronounced difference between the two methods is the nature of the assets they deal with. Depreciation is for tangible assets, such as buildings, machinery, and vehicles. On the other hand, amortization is for intangible assets like patents, trademarks, and copyrights.
2. Method of Calculation
One significant amortization and depreciation difference is in the way both are calculated.
Unlike amortization, which only employs straight-line depreciation techniques for valuation purposes, depreciation can be calculated in four ways based on the type of asset and your end goal. Here are some commonly used techniques in calculating depreciation:
- Straight line method: This is the simplest calculation method. Here, the salvage value of an asset is deducted from the actual value. The remaining cost is divided by the number of useful years for the depreciation.
- Declining balance method: Accelerated depreciation method where a higher expense is recorded in the earlier years of an asset’s life, which tapers off in the later years. Often, a double the straight-line rate is applied, called a “Double Declining Balance.”
- The sum of the years’ digits method: This is another accelerated depreciation method. Here, the sum of the asset’s useful life years is calculated. For example, if the useful life is four years, the sum is 4+3+2+1=10. In the first year, 4/10 of the depreciable amount is expensed; in the second year, 3/10, and so on.
- Units of production: In this method, depreciation is based on actual usage or production rather than the passage of time. This is suitable for assets where wear and tear are more linked to the number of units produced than age. Here, the depreciation rate is calculated per unit and multiplied by actual production.
3. Application
Where depreciation determines the disposal value of real-life assets like property, machinery, tools, and equipment, amortization typically emerges during mergers and acquisitions, especially when a business acquires another.
Similarities in Amortization vs Depreciation
There are several points of difference between depreciation and amortization, but these methods also have a few similarities.
For instance, the amortization and depreciation expenses are cashless. There is no actual cash expense made for these costs. As a result, these costs are recorded as reductions in the value of assets on financial reports.
Amortization vs Depreciation Example
Let’s take an example to properly understand the difference between depreciation and amortization.
Imagine a company that has recently acquired a patent for a new product for Rs. 1,00,000. They’ve also purchased a manufacturing machine to produce this product for Rs. 50,000 with a useful life of 5 years and a salvage value of Rs. 10,000.
For simplicity’s sake, let’s use a straight-line depreciation method to calculate amortization and depreciation.
Amortization: Amortization is calculated by dividing the value of the patent by its useful life. If we take eight years as the useful life, the amortization of the patent comes out to:
100000/8 = Rs. 12,500/year
Depreciation: Depreciation is calculated by first deducting the salvage value of the machine from its original cost, which gives you the total depreciation of value. You get the depreciation per year by dividing this value by useful life.
Total depreciation of value: 50000-10000= Rs. 40,000.
Depreciation: 40000/5 = Rs. 8000/year.
So, in a nutshell, the company has to bear an annual amortization expense of Rs. 12,500 and a yearly depreciation expense of Rs. 40,000.
Final Thoughts
Now that you know the key difference between depreciation and amortization, you can make an informed decision regarding your business expenses and budget.
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06 October 2023
6 mins read
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