What is Amortization?
Amortization is an accounting method used to spread the cost of an intangible asset over its useful life. Intangible assets, such as patents, copyrights, trademarks, and goodwill are those assets that have no physical presence but have value because of the rights or privileges they grant to the owner. Amortization allows the cost of these assets to be allocated over their expected useful life in a systematic and rational manner.
The primary objective of amortization is to match the cost of an intangible asset with the revenue it generates over its useful life. This process helps to ensure that the expenses associated with the asset are recognized in the same accounting period as the revenue generated from its use. This approach provides a more accurate picture of the company’s financial performance and helps to avoid the distortion of earnings due to the lump-sum recognition of the cost of the asset in the year it was acquired.
There are two ways to calculate amortization:
- Straight-line method
- Declining balance method or accelerated method
The straight-line method is the most commonly used method for calculating amortization. Under this method, the cost of the intangible asset is divided by its expected useful life to determine the annual amortization expense. For example, suppose a company pays $60,000 for a patent with a useful life of 10 years. In that case, the annual amortization expense would be $6,000 ($60,000/10 years).
Declining balance method involves higher amortization expenses in the earlier years of the asset’s useful life and lower expenses in the later years. For example a machine purchased at $10000, if we assume 30% amortization rate, the amortization expense in the first year would be $3000. For the second year, it would be 30% of $7000, which is $2100 and so on. Since the amounts being spread out are greater in the first few years after the equipment purchase, they further reduce a company’s earnings before tax during that period. This method is suitable for intangible assets that have a higher value or usage in their earlier years.
When an amortization expense is charged to the income statement, the value of the asset recorded on the balance sheet is reduced by the same amount. This continues until the asset is fully expensed or the asset is sold or replaced.
Certain intangible assets may have indefinite useful lives. In such cases, the company cannot determine the exact useful life of the asset, and so it is not subject to amortization. However, the company must periodically evaluate the asset’s carrying value to determine if there has been any impairment of its value.
Amortization has several advantages for businesses, including:
- Amortization helps companies to match the cost of intangible assets with the revenue generated from their use, providing a more accurate picture of the company’s financial performance.
- Amortization enables companies to better manage their intangible assets by ensuring they are being used efficiently and generating sufficient revenue.
- Amortization of intangible assets is usually deductible for tax purposes, which can result in tax savings for the company.
What is Depreciation?
Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. Tangible assets are those assets that have a physical presence, such as buildings, machinery, vehicles, and furniture. Depreciation allows businesses to spread out the cost of these assets over their expected useful life, which helps to match the expenses with the revenue generated by the asset during that period.
The primary objective of depreciation is to recognize the wear and tear or obsolescence of the asset and the decrease in its value over time. This approach provides a more accurate picture of the asset’s true value and helps businesses to plan for the replacement or upgrade of the asset when its useful life is over.
Methods used to calculate depreciation include:
- Straight-line method
- Declining balance method or accelerated method
- Units-of-production method
The straight-line method is the most common and straightforward method of calculating depreciation, where the cost of the asset is divided by its useful life to determine the annual depreciation expense. For example, if a company purchases a machine for $100,000 with a useful life of 10 years, the annual depreciation expense would be $10,000 ($100,000/10 years).
With the declining balance depreciation method, the asset is depreciated by the same rate for each year of its useful life. This method is sometimes used to reflect the fact that assets lose more value early in their life.
For example, for the machine above, using a 30% depreciation rate, the depreciation expense is $3,000 in the first year, $2,100 the second year, $1,470 the third year and so on.
Declining balance method, result in higher depreciation expenses in the earlier years of the asset’s useful life and lower expenses in the later years. This method is suitable for assets that have a higher value or usage in their earlier years.
The units-of-production method involves calculating depreciation based on the number of units produced or hours of usage of the asset. This method is suitable for assets that are used in production or manufacturing, where the asset’s useful life is related to its usage.
When a depreciation expense is charged to the income statement, the value of the asset recorded on the balance sheet is reduced by the same amount. This continues until the asset is fully expensed or the asset is sold or replaced.
Depreciation has several advantages for businesses, including:
- Depreciation helps companies to match the cost of tangible assets with the revenue generated from their use, providing a more accurate picture of the company’s financial performance.
- Depreciation enables companies to better manage their tangible assets by ensuring they are being used efficiently and generating sufficient revenue.
- Depreciation of tangible assets is usually deductible for tax purposes, which can result in tax savings for the company.
Key Differences
- Definition: Amortization is the process of spreading the cost of an intangible asset (such as a patent or copyright) over its useful life, while depreciation is the process of spreading the cost of a tangible asset (such as a building or equipment) over its useful life.
- Type of assets: Amortization is used for intangible assets such as patents, copyrights, trademarks, goodwill, etc., while depreciation is used for tangible assets such as buildings, machinery, furniture, and vehicles.
- Useful life: The useful life of an intangible asset is usually limited by law, contract, or estimate, while the useful life of a tangible asset is typically based on the expected physical wear and tear or technological obsolescence.
- Calculation method: Amortization is calculated using the straight-line method, which involves dividing the cost of the asset by its estimated useful life. Depreciation can be calculated using different methods such as straight-line, accelerated, or units-of-production method.
- Rate of depreciation/amortization: The rate of depreciation or amortization is usually based on an estimate of the asset’s useful life and the expected residual value at the end of that period. Amortization rates are generally higher than depreciation rates due to the fact that intangible assets often have a shorter useful life than tangible assets.
- Tax treatment: Amortization and depreciation have different tax treatment. Amortization of intangible assets is usually deductible for tax purposes, while depreciation of tangible assets may be deductible or subject to special rules.
- Impact on financial statements: Amortization and depreciation have different impacts on the financial statements. Amortization is recorded as an expense on the income statement, while depreciation is recorded as an expense on the income statement and as a reduction of the asset’s book value on the balance sheet.
- Residual value: The residual value of an intangible asset is usually negligible, while the residual value of a tangible asset can be significant. This affects the calculation of depreciation and amortization.
- Legal requirements: Some intangible assets are required by law to be amortized, while there are no legal requirements to depreciate tangible assets.
- Effect on asset value: Amortization reduces the value of an intangible asset to zero over its useful life, while depreciation reduces the book value of a tangible asset to its estimated residual value. As a result, the remaining value of a tangible asset after its useful life may be higher than that of an intangible asset.