The cost of business assets can be expensed each year over the life of the asset. The expense amounts are subsequently used as a tax deduction reducing the tax liability for the business.
Because very few assets last forever, a finite number of years is calculated which is called the asset's useful life. In this article, we'll review three common methods used by business to spread out the cost of an asset. The key difference between all three methods involves the type of asset being expensed.
Depreciation is the expensing of fixed assets over its useful life. Fixed assets are tangible assets meaning they are physical assets and can be touched. Some examples of fixed or tangible assets that are commonly depreciated include:
- Office furniture
Since tangible assets might have some value at the end of their life, depreciation is calculated by subtracting the asset's salvage value or resale value from its original cost. The difference is depreciated evenly over the years of the expected life of the asset. In other words, the depreciated amount expensed in each year is a tax deduction for the company until the useful life of the asset has expired.
For example, an office building can be used for many years before it becomes run down and is sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed in each accounting year.
Depreciation of some fixed assets can be done on an accelerated basis, meaning that a larger portion of the asset's value is expensed in the early years of the assets' life. For example, vehicles are typically depreciated on an accelerated basis.
Amortization is the practice of spreading an intangible asset's cost over that asset's useful life. Intangible assets are not physical assets per se. Examples of intangible assets that are expensed through amortization might include:
- Patents and trademarks
- Franchise agreements
- Proprietary processes like copyrights
- Cost of issuing bonds to raise capital
- Organizational costs
Unlike depreciation, amortization is typically expensed on a straight-line basis, meaning the same amount is expensed in each period over the asset's useful life. Also, assets that are expensed using the amortization method typically don't have any resale or salvage value, unlike with depreciation.
It's important to note the context when using the term amortization since it carries another meaning. An amortization schedule is often used to calculate a series of loan payments consisting of both principal and interest in each payment as in the case of a mortgage. The term amortization is used in both accounting and in lending with completely different definitions and uses.
Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs are spread out over the predicted life of the well.
With depreciation, amortization, and depletion all three methods are noncash expenses with no cash spent in the years they are expensed. Also, it's important to note that in some countries, such as Canada, the terms amortization and depreciation are often used interchangeably to refer to both tangible and intangible assets.