Amortization vs depreciation: the differences explained

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Amortization vs depreciation: an overview

The cost of business assets can be expensed annually over the life of the asset. Amortization and depreciation are two methods of calculating the value of these business assets. The expense amounts are then used as a tax deduction reducing the tax payable for the business. In this article, we’ll go over depreciation, depreciation, and another method commonly used by businesses to allocate the cost of an asset. The main difference between the three methods is the asset type being expensed.

Key points to remember

  • Amortization and depreciation are two methods of calculating the value of business assets over time.
  • A business will calculate these expense amounts in order to use them as a tax deduction and reduce its tax liability.
  • Depreciation is the practice of allocating the cost of an intangible asset over the useful life of that asset.
  • Depreciation is the expensing of an asset over its useful life.
  • A third method of expensing business assets is the depletion method, which is an accrual accounting method used by businesses that extract natural resources from the earth, such as timber, petroleum. and minerals.

Amortization

Depreciation is the practice of allocating the cost of an intangible asset over the useful life of that asset. Intangible assets are not physical assets per se. The following are examples of intangible assets that are expensed through amortization:

  • Patents and Trademarks
  • Franchise agreements
  • Proprietary processes, such as copyright
  • Cost of issuing bonds to raise capital
  • Organization costs

Unlike depreciation, depreciation is typically expensed on a straight-line basis, which means the same amount is expensed every period over the useful life of the asset. Additionally, assets that are expensed using the depreciation method typically have no resale or salvage value, unlike depreciation.

It is important to note the context when using the term damping as it carries another meaning. An amortization schedule is often used to calculate a series of loan payments that include both principal and interest on each payment, as in the case of a mortgage.

The term amortization is used in both accounting and credit with completely different definitions and uses.

Depreciation

Depreciation is the expensing of an asset over its useful life. Fixed assets are tangible assets, that is, physical assets that can be affected. Here are some examples of capital assets or tangible assets that are commonly depreciated:

  • Buildings
  • Equipment
  • Office furniture
  • Vehicles
  • Earth
  • Machinery

Since tangible assets may have a certain value at the end of their useful life, depreciation is calculated by subtracting the salvage value or the resale value of the asset from its original cost. The difference is amortized evenly over the years of the expected life of the asset. In other words, the amortized amount expensed each year is a tax deduction for the business until the expiration of the asset’s useful life.

For example, an office building can be in use for many years before it becomes run down and sold. The cost of the building is spread over the expected life of the building, with part of the cost expensed in each financial year.

Depreciation of some fixed assets can be done on an accelerated basis, which means that more of the value of the asset is expensed in the early years of the asset’s life. For example, vehicles are generally depreciated on an accelerated basis.

Special considerations

Depletion is another way of costing business assets. It is the distribution 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 costs of installing the oil well are spread over the expected life of the well.

The two basic forms of the depletion allowance are percentage depletion and cost depletion. The percentage depletion method allows a company to assign a fixed percentage of depletion to the gross income earned from natural resource extraction. The cost depletion method takes into account the basis of ownership, the total recoverable reserves and the number of units sold.

Together with depreciation, amortization, and depletion, the three methods are non-cash expenses with no cash spent in the years they are expensed. Additionally, it is 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.


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