Depreciation vs. Amortization: Definitions and Examples
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It's essential to understand depreciation and amortization to make intelligent decisions if you work in business, finance, or real estate. The primary difference between amortization and depreciation is that amortization applies to intangible assets and depreciation applies to tangible assets. Understanding these two terms can enable you to make better financial decisions that may save you or your clients time and money. In this article, we compare depreciation vs. amortization, discover the key differences between the two, list a few examples of each, and answer some frequently asked questions.
Depreciation vs. amortization
You may be interested in comparing depreciation vs. amortization if you have a business or want to learn more about calculating asset value. Amortization refers to reducing the cost of an intangible asset over a certain period. Intangible assets are non-physical assets that are essential to an operation, such as patents, trademarks, and copyrights. The goal of amortizing an asset is to match its acquisition expense with the revenue it generates. Businesses typically use amortization for assets without a resale or salvage value. Here are examples of intangible assets that are expensed through amortization:
Intellectual property, including patents and trademarks
Proprietary processes, including copyrights
Costs associated with issuing bonds to raise capital
Costs of organization
Depreciation refers to reducing the long-term expenses of tangible assets. The purpose of depreciation is to match the cost of purchasing an asset with the income it generates for a business. Depreciation applies to tangible assets, such as manufacturing equipment, vehicles, and computers. An asset's depreciation rate specifies how much of its value it's consumed. Tangible assets often maintain some value after the completion of their estimated life expectancy. The remaining value of the tangible asset is the salvage or resale value of the asset, which is deducted from the original purchase price. Here are examples of tangible assets:
Key differences between amortization and depreciation
Both amortization and depreciation determine the value of assets within a business. These two concepts also differ in several ways. A significant difference between depreciation and amortization is that depreciation pertains to tangible assets and amortization pertains to intangible assets. There is also a difference in the method of calculation for depreciation and amortization. A business can only calculate amortization using the straight-line method, while it can calculate depreciation using either the straight-line or accelerated method.
The straight-line method refers to depreciating and amortizing an asset over a longer period. A company calculates straight-line depreciation and amortization by dividing the difference between its cost and its expected salvage value by the expected number of years of utilization. The accelerated method of depreciation refers to the practice of depreciating tangible assets over their useful lives at a faster rate than the straight-line method of depreciation.
As an example of depreciation, an organization purchases a piece of new equipment for $100,000 with an estimated useful life of 10 years. Using the straight-line method, the company expects to depreciate the equipment at an annual rate of $10,000 over the next 10 years. The company can also decide to use accelerated depreciation, in which the amount of depreciation each year increases during the early years of the asset's life. The two accelerated depreciation methods are the double-declining balance and the sum of the years' digits. Here are examples of each type of accelerated method:
Double-declining balance (DDB)
To use the double-declining balance method, you double the reciprocal of an asset's useful life. The new rate then applies to the depreciable base for the remaining useful life of the asset. The reciprocal of a number is one divided by the original number. For example, if an asset costs $100,000 and has a useful life of 10 years, the reciprocal value is 1/10 or 10%. Doubling the rate results in 20% depreciation. This means that the asset's value depreciates by 20% per year.
Sum of the years' digits (SYD)
The sum of the years' digits method involves adding all the digits of the asset's expected life. For example, an asset worth $100,000 with a 10-year life has a base equal to the sum of adding each digit between one and 10, which equals 55. In the first depreciation year, 10/55, or 18% of the $100,000 value depreciates. In the second year, 9/55, or 16% of the asset value depreciates. This continues until year 10 depreciates.
An example of amortization is a company that spends $50,000 to get a licence that expires in 10 years. As an intangible asset, the company can amortize the licence for 10 years before its expiration. This means that the company is incurring an expense of $50,000 over the next 10 years. The straight-line method concedes that the asset's value depreciates by $5,000 every year. Using the straight-line method, the value of the asset depreciates by $5,000 each year.
Depreciation and amortization FAQs
Here are a few frequently asked questions about depreciation and amortization:
Why do companies use depreciation?
By depreciating assets, companies can recover the cost of the assets they purchase. This allows companies to pay for the entire cost of an asset over its life cycle, instead of recovering the capital investment. Using the depreciation method, companies can accurately report the costs of using assets and their revenue from the asset. Companies can overstate or understate their total asset expenses without depreciation, which can lead to misleading financial statements. Depreciation is also tax deductible. Higher depreciation expenses reduce taxable income and increase tax savings.
Why do businesses use amortization?
Businesses and investors can understand and forecast future costs using amortization schedules that show what portion of loan repayment is interest and what portion is principal. Principal payments are payments that help repay the original loan amount. An interest charge is a monetary charge associated with the authorization to borrow money, usually expressed as an annual percentage rate (APR). Deducting amortization expenses lowers taxable earnings and reduces taxable income at year-end. Until an intangible asset no longer has value, you can deduct a portion of its cost.
What does tax deductible mean?
Deductions are expenses that individual taxpayers or businesses can deduct from their adjusted gross income when completing a tax form. By reducing taxable income, deductible expenses reduce the amount of taxes owed. Individuals often deduct interest paid on student loans, self-employment expenses, donations to charities, and mortgage interest. A business's deductibles include payroll, utilities, rent, leases, and various operating expenses. The following are a few of the top deductions for business owners:
Public relations and advertising
Travelling for business
Contributions to charities
Costs associated with legal and professional services
Licensing fees and regulatory fees
Interest rates on loans
Maintenance and repair work
Sales and property taxes
Expenses associated with vehicle maintenance
Costs involved in starting a business
What defines a company's income?
A company's income, also known as its revenue, is the profit it receives when it sells goods or provides services. Your income may come from a steady source, such as a store or factory selling goods, and a hotel or advertising agency providing services. A company can also earn income through one-time events, like the sale of real estate or the sale of securities owned by the company. The income statement is a financial statement that summarizes the income of an organization.
Many companies distinguish between operating revenues generated by their core business activities and non-operating revenues as part of their overall revenue distribution. A business's operating revenue generates from its sales of products and services. For example, a bakery may earn income from selling pies. Revenue from non-operating activities corresponds to income generated by activities unrelated to the operations of the company, such as dividends or investment returns.
What defines a company's expenses?
A company incurs expenses to generate revenue. Expenses are the costs of operating the business. Business expenses can include salaries, office supplies, shipping, regulatory fines, legal fees, and the cost of goods sold. There are several types of business expenditures. Some expenses directly relate to daily operations, such as sales prices and employee wages, while others are recurring, such as rent and interest on borrowed funds. Onetime expenses may also occur, such as litigation settlements or investment losses. Most company expenses are deductible from taxable income. Tax-deductible expenses include depreciation, amortization, rent, salaries, wages, benefits, and marketing.
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