Depreciation versus Amortization
🔍 What is Depreciation?
📌 Definition:
Depreciation is the process of allocating the cost of a tangible fixed asset (like machinery, buildings, or vehicles) over its useful life.
🧩 Key Features:
- Applies to tangible assets (physical assets).
- Reflects the decline in value due to use, wear and tear, or obsolescence.
- Common methods: Straight Line, Written Down Value, Units of Production, etc.
📌 Example:
A company buys a machine for $50,000 with a 10-year useful life and no salvage value.
Using straight-line depreciation:
So, every year, the company records a $5,000 expense for depreciation.
🔍 What is Amortization?
📌 Definition:
Amortization is the process of allocating the cost of an intangible asset (like patents, trademarks, copyrights, or software) over its useful life.
🧩 Key Features:
- Applies to intangible assets (non-physical assets).
- Reflects the loss of value over time, often due to expiration or legal restrictions.
- Usually follows the straight-line method, but can vary.
📌 Example:
A company acquires a patent for $200,000 with a 20-year useful life.
$$ \text{Annual Amortization} = \frac{200,000 - 0}{20} = \$10,000 $$So, each year, the company records a $10,000 amortization expense.
✅ Key Differences Between Depreciation and Amortization
| Feature | Depreciation | Amortization |
|---|---|---|
| Type of Asset | Tangible assets (machines, buildings, etc.) | Intangible assets (patents, trademarks, etc.) |
| Purpose | To account for physical wear and tear | To account for loss of value over time |
| Common Method | Straight line, reducing balance, units | Usually straight line |
| Salvage Value | May be considered | Not typically considered |
| Example | A factory building | A trademark |
🧠 Summary Table
| Term | Type of Asset | Purpose | Method Used |
|---|---|---|---|
| Depreciation | Tangible | Physical wear & tear | Straight line, etc. |
| Amortization | Intangible | Loss of value due to expiration | Straight line |
💡 Important Notes:
- Both are non-cash expenses that reduce net income.
- They help match the cost of the asset with the revenue it generates over time.
- In some countries (like the U.S.), amortization may also be used for loan repayments, which is different from accounting amortization.
📌 When to Use Each:
- Use depreciation for physical assets like:
- Buildings
- Vehicles
- Equipment
- Computers
- Use amortization for intangible assets like:
- Patents
- Trademarks
- Software
- Licenses
✅ Final Thought:
While depreciation and amortization are similar in purpose (allocating asset cost over time), they differ in the type of asset they apply to. Understanding this distinction is essential for accurate financial reporting and tax compliance.
Let me know if you’d like examples of journal entries for depreciation or amortization!