Amortization vs. Depreciation: An Overview
When a company acquires an asset, that asset may have a long useful life. Whether it is a company vehicle, goodwill, corporate headquarters, or a patent, that asset may provide benefit to the company over time as opposed to just in the period it is acquired. To more accurately reflect the use of these types of assets, the cost of business assets can be expensed each year over the life of the asset. The expense amounts are then used as a tax deduction, reducing the tax liability of the business.
Amortization and depreciation are the two main methods of calculating the value of these assets, with the key difference between the two methods involving the type of asset being expensed. In addition, there are differences in the methods allowed, components of the calculations, and how they are presented on financial statements.
- Amortization and depreciation are two methods of calculating the value for business assets over time.
- Amortization is the practice of spreading an intangible asset's cost over that asset's useful life.
- Depreciation is the expensing a fixed asset as it is used to reflect its anticipated deterioration.
- Amortization and depreciation differ in that there are many different depreciation methods, while the straight-line method is often the only amortization method used.
- The two accounting approaches also differ in how salvage value is used, whether accelerated expensing is done, or how each are shown on the financial statements.
Amortization is the accounting practice of spreading the cost of an intangible asset over its useful life. Intangible assets are not physical in nature but they are, nonetheless, assets of value. Examples of intangible assets that are expensed through amortization include patents, trademarks, franchise agreements, copyrights, costs of issuing bonds to raise capital, or organizational costs.
Amortization is typically expensed on a straight-line basis. That means that the same amount is expensed in each period over the asset's useful life. Assets that are expensed using the amortization method typically don't have any resale or salvage value.
The term "amortization" is used in another, unrelated, context. 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. Though different, the concept is somewhat similar; as a loan is an intangible item, amortization is the reduction in the carrying value of the balance.
The term amortization is used in both accounting and in lending with completely different definitions and uses.
Depreciation is the expensing of a fixed asset over its useful life. Fixed assets are tangible objects acquired by a business. Some examples of fixed or tangible assets that are commonly depreciated include buildings, equipment, office furniture, vehicles, and machinery.
Unlike intangible assets, tangible assets might have some value when the business no longer has a use for them. For this reason, 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, a business may buy or build an office building, and use it for many years. The business then relocates to a newer, bigger building elsewhere. The original office building may be a bit rundown but it still has value. The cost of the building, minus its resale value, 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 asset's life. Vehicles are typically depreciated on an accelerated basis.
The definition of depreciate is "to diminish in value over a period of time".
Companies often have several options when choosing their depreciation method. The most common depreciation methods include:
- Straight-Line Method: A company depreciates the asset equally over the term of its useful life. The depreciable base is determined by taking the asset's cost and reducing the salvage value. The same amount of depreciation is recorded each year.
- Declining Balance: A company depreciates an accelerated amount of depreciation earlier in the asset's useful life. This is done by multiplying the current book value of the asset by a fixed depreciation rate that does not change over the life of the asset.
- Double Declining Balance Method: A company depreciates an accelerated amount of depreciation earlier in the asset's useful life by doubling the rate under the straight-line method. This rate is then applied to the current book value.
- Sum-of-the-Years' Digits Method: The digits of the asset's useful life are summed (i.e. an asset with a useful life would add up to 5+4+3+2+1 = 15 years). Then, a company depreciates a proportion of costs based on the corresponding digit (i.e. 5/15 for Year 1, 4/15 for Year 2).
- Units of Production: A company assesses a baseline of anticipated usage. For example, a company buys a company vehicle and intends on driving it 100,000 miles. Each year, it assesses its actual use (i.e. 17,000 miles driven in year one) to determine what proportion to depreciation (i.e. 17% of the depreciable base in year one).
By definition, depreciation is only applicable to physical, tangible assets subject to having their costs allocated over their useful lives. Alternatively, amortization is only applicable to intangible assets.
The term 'depreciate' means to diminish something value over time, while the term 'amortize' means to gradually write off a cost over a period. Conceptually, depreciation is recorded to reflect that an asset is no longer worth the previous carrying cost reflected on the financial statements. Meanwhile, amortization is recorded to allocate costs over a specific period of time. Both methods appear very similar but are philosophically different.
Options of Methods
Almost all intangible assets are amortized over their useful life using the straight-line method. This means the same amount of amortization expense is recognized each year. On the other hand, there are several depreciation methods a company can choose from. These options differentiate the amount of depreciation expense a company may recognize in a given year, yielding different net income calculations based on the option chosen.
Of the different options mentioned above, a company often has the option of accelerating depreciation. This means more depreciation expense is recognized earlier in an asset's useful life as that asset may be used heavier when it is newest. Tangible assets can often use the modified accelerated cost recovery system (MACRS). Meanwhile, amortization often does not use this practice, and the same amount of expense is recognized whether the intangible asset is older or newer.
Use of Salvage Value
The formulas for depreciation and amortization are different because of the use of salvage value. The depreciable base of a tangible asset is reduced by the salvage value. The amortization base of an intangible asset is not reduced by the salvage value. This is often because intangible assets do not have a salvage, while physical goods (i.e. old cars can be sold for scrap, outdated buildings can still be occupied) may have residual value.
Use of Contra Account
Depending on the asset and materiality, the credit side of the amortization entry may go directly to to the intangible asset account. On the other hand, depreciation entries always post to accumulated depreciation, a contra account that reduces the carrying value of capital assets.
Applies only to physical assets
Philosophically reduces an asset's value
Has many different methods a company may choose from
May result in accelerated, inconsistent amounts recorded each year
May incorporate salvage value when determining depreciation base
Always uses contra assets
Applies only to intangible assets
Philosophically spreads an asset's cost
Generally is only done using the straight-line method
Often results in the same amount recorded each year
Does not incorporate salvage value when determining amortization base
May not always use contra assets
Amortization vs. Depreciation Example
As part of its 2021 annual report, Amazon included full-year comparative financial statements accompanied by financial statement notes. As shown on the company's statement of cash flow, Amazon aggregated depreciation and amortization, reporting $34,296 of combined activity.
As is standard in financial statement disclosures, Amazon explains how it approaches depreciation and amortization. For both, the company uses the straight-line method. However, it uses a wide range of useful lives depending on the underlying asset being adjusted for.
At the end of 2021, Amazon reported $238.8 billion of gross property and equipment. However, of this, $78.5 billion of total accumulated depreciation and amortization had been recognized. This means that roughly 1/3 of the company's fixed assets had been depreciated. In addition, you'll note that land is being included in this section (which is non-depreciable). At the end of the year, Amazon reported $160.3 billion of net property and equipment.
Last, Amazon provided additional detail regarding its intangible assets. It classified it intangible assets as either finite-lived or in-process used in research and development. Most of the company's intangible assets were finite-lived, with most of them being either marketing-related or contract-based. At the end of 2021, the company had almost $7 billion of intangible assets, though the company had accumulated amortization of over $1.8 billion.
Depletion is another way that the cost of business assets can be established in certain cases. It is relevant only to the valuation of natural resources. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs can be spread out over the predicted life of the well.
The two basic forms of depletion allowance are percentage depletion and cost depletion. The percentage depletion method allows a business to assign a fixed percentage of depletion to the gross income received from extracting natural resources. The cost depletion method takes into account the basis of the property, the total recoverable reserves, and the number of units sold.
One of the primary similarities between depreciation and amortization (and depletion) is the recognition of an expense without the associated cash flow. For this reason, depreciation and amortization are both very misleading expenses that may be omitted from certain reports to better clarify operating needs.
For example, a company often must often treat depreciation and amortization as non-cash transactions when preparing their statement of cash flow. Without this level of consideration, a company may find it more difficult to plan for capital expenditures that may require upfront capital.
Correction—Jan. 20, 2022: An earlier version of this article erroneously listed land as an asset that could be depreciated. Land can never be depreciated, according to the IRS.
What Is an Example of Amortization?
A company may amortize the cost of a patent over its useful life. Say the company owns the exclusive rights over a patent for 10 years, and the patent is not to renew at the end of the period. The company may amortize the cost of the patent for the decade, recognizing 10% of the expenses each year. Through amortization, the carrying value of the trademark decreases.
What Is an Example of Depreciation?
The sum-of-the-years digits method is an example of depreciation in which a tangible asset like a vehicle undergoes an accelerated method of depreciation. Under the sum-of-the-years digits method, a company recognizes a heavier portion of depreciation expense during the earlier years of an asset's life. In theory, more expense should be expensed during this time because newer assets are more efficient and more in use than older assets.
Why Do We Amortize a Loan Instead of Depreciate a Loan?
Loans are amortized because they are intangible. A loan doesn't deteriorate in value or become worn down over use like physical assets do. Loans are also amortized because the original asset value holds little value in consideration for a financial statement. Though the notes may contain the payment history, a company only needs to record its currently level of debt as opposed to the historical value less a contra asset.
How Do I Know Whether to Amortize or Depreciate an Asset?
Generally speaking, there is accounting guidance via GAAP on how to treat different types of assets. Accounting rules stipulate that physical, tangible assets (with exceptions for non-depreciable assets) are to be depreciated, while intangible assets are amortized.
Is It Better to Amortize or Depreciate an Asset?
It is neither better to amortize or depreciate an asset. Instead, there is accounting guidance that determines whether it is correct to amortize or depreciate an asset. Both terminologies spread the cost of an asset over its useful life, and a company doesn't gain any financial advantage through one as opposed to the other.
The Bottom Line
Two common techniques are used to reflect the benefit of an asset and its associated costs over a period of time. Both depreciation and amortization reduce the carrying value of assets and recognize expenses as assets are used over time. However, depreciation is used for physical assets, while amortization is used for intangible assets. In addition, there are differences in the methods available, acceleration options, how salvage value is used, and how contra accounts are used.