Depreciation and amortization are both accounting methods used to spread the cost of an asset over its useful life, rather than expensing the entire cost in the year of purchase. This helps businesses match the cost of an asset with the revenue it generates over time and provides a more accurate picture of profitability.
Depreciation
- What it is: Depreciation is the accounting process of allocating the cost of a tangible asset (a physical asset like machinery, vehicles, buildings, or equipment) over its useful life. It reflects the asset's decrease in value due to wear and tear, obsolescence, or usage.
- Why it's used: Instead of recording the full cost of an expensive asset in one year, depreciation allows businesses to expense a portion of that cost each year it's used. This helps in tax calculations by reducing taxable income.
- Example: If a company buys a machine for $100,000 that is expected to last 10 years, they might depreciate $10,000 each year for 10 years.
- Key characteristics:
- Applies to tangible assets.
- Can be calculated using various methods, with "straight-line depreciation" being the simplest and most common, where the value is spread evenly over the asset's life.
- Tangible assets may have a "salvage value" (resale value) at the end of their useful life.
Amortization
- What it is: Amortization is the accounting process of spreading the cost of an intangible asset (a non-physical asset like patents, copyrights, trademarks, or software licenses) over its useful life. It also refers to the process of paying off a debt over time through regular installments.
- Why it's used: Similar to depreciation, it allows businesses to expense the cost of intangible assets over the period they provide value. For loans, it provides a structured way to repay both principal and interest over a set period.
- Example: If a business purchases a patent for $10,000 with a useful life of 5 years, they might amortize $2,000 per year for 5 years.
- Key characteristics:
- Primarily applies to intangible assets.
- Most commonly calculated using the "straight-line method," where the cost is spread evenly.
- Intangible assets typically do not have a salvage value.
- Also used for loan repayment schedules, where each payment includes both principal and interest.
Key Differences Summarized:
The main distinction between depreciation and amortization lies in the type of asset they apply to:
- Depreciation: For tangible (physical) assets.
- Amortization: For intangible (non-physical) assets, and also for the repayment of loans.