Depreciation and Amortization on the Income Statement. If you want to invest in a publicly-traded company, performing a robust analysis of its income statement can help you determine the company’s financial performance.
There are many different terms and financial concepts incorporated into income statements. Two of these concepts depreciation and amortization can be somewhat confusing, but they are essentially used to account for decreasing the value of assets over time.
Specifically, amortization occurs when the depreciation of an intangible asset is split up over time, and depreciation occurs when a fixed asset loses value over time.
Amortization vs. Depreciation: An Overview
The cost of business assets can be expensed each year over the life of the asset, and amortization and depreciation are two methods of calculating value for those business assets.
The expense amounts are subsequently used as a tax deduction reducing the tax liability for the business. In this article, we’ll review amortization, depreciation, and one more common method used by businesses to spread out the cost of an asset. The key difference between all three methods involves the type of asset being expensed.
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, such as 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. Additionally, 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.
Depreciation is the expensing of a fixed asset over its useful life. Fixed assets are tangible assets, meaning they are physical assets that 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 asset’s life. For example, vehicles are typically depreciated on an accelerated basis.
Depreciation and Amortization Differences :
The key difference between amortization and depreciation is that amortization is used for intangible assets, while depreciation is used for tangible assets.
Another major difference is that amortization is almost always implemented using the straight-line method, whereas depreciation can be implemented using either the straight-line or accelerated method.
Finally, because they are intangible, amortized assets do not have a salvage value, which is the estimated resale value of an asset at the end of its useful life. Depreciated assets, by contrast, often have a salvage value. An asset’s salvage value must be subtracted from its cost to determine the amount in which it can be depreciated.
- 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 of a fixed asset over its useful life.
A business should realize the importance of these two accounting concepts and should be analyzed which most importance on how much money needs to be set aside to purchase an asset in the future.
Also, assets of the business should always be tested for impairment at least annually which helps the business to know the real market value of the asset. The impairment of assets also helps the business to forecast the cash requirement and at which year the probable cash outflow should occur.