Amortization writes off the cost of an intangible asset over its useful life, while depreciation tracks loss in value for tangible assets.
Depreciation and amortization are methods by which you can spread out the cost of an asset over time. These expenses can then be utilized as tax deductions to lessen your company’s tax liability.
Depreciation describes expensing a fixed asset over the span of its useful life. Physical assets include:
As these assets operate and deteriorate over time, they experience a decline in value. Accordingly, depreciation expenses are recognized as deductions for tax purposes.
The annual depreciation expense you write off each year covers the majority of this loss with salvage value (or resale value) comprising the remainder. This residual value is not factored into the loss, since you can recoup these costs by reselling the resource or property.
Amortization is always calculated using the straight-line method of depreciation. Depreciation, however, can be calculated using straight-line or accelerated methods. For tax purposes, your company can report higher expenses in the early years of an asset’s useful life.
The IRS outlines best practices on recovering the cost of business or income-producing property through deductions.
Depreciation Expense =
(cost - salvage value) x # of years left in asset life /
sum of years in asset life
Amortization describes the annual depreciation of an intangible asset over the span of its useful life. Intangible assets include:
You can calculate amortization using the straight-line depreciation method. This means that the annual amortization expense you write off each year remains fixed throughout the life of the asset.
The term “amortization” can also apply to concepts outside of accounting, for example utilizing an “amortization schedule” to calculate the principal and interest in a sequence of loan payments. Though these terms refer to two separate ideas, the process is essentially the same. A mortgage loan, for example, will diminish in carrying value as you pay off the balance.
Although both amortization and depreciation calculate the expenses associated with assets over time, there are some key differences between these accounting approaches:
|Type of Asset||Tangible||Intangible|
|Residual Value||Residual salvage value||No salvage value|
|Formula||(Tangible Asset - Salvage Value) / Useful Life||(Cost of Intangible Asset) / Useful Life|
|Purpose||Tracks diminishing value over time||Allocates costs over time|
Amortization and depreciation both track business assets but also share some other characteristics:
Depreciation Sample - Declining Balance Method
Your manufacturing facility makes a $50,000 purchase for a piece of equipment with a useful life of ten years. The salvage value at the end of its useful life is $5,000, with a depreciation rate of 20%.
Your yearly depreciation amount will be highest in the early years of your asset’s life. This method is ideal for assets like computers, cell phones, and vehicles that are quickly made obsolete by newer models.
|Year||Depreciation Equation||Yearly Depreciation Amount||End-of-Year Value|
|1||20% x $50,000||$10,000||$40,000|
|2||20% x $40,000||$8,000||$32,000|
|3||20% x $32,000||$6,400||$25,600|
|4||20% x $25,600||$5,120||$20,480|
|5||20% x $20,480||$4,096||$16,384|
|6||20% x $16,384||$3,277||$13,108|
|7||20% x $13,108||$2,621||$10,487|
|8||20% x $10,487||$2,097||$8,390|
|9||20% x $8,390||$1,678||$6,712|
|10||20% x $6,712||$1,342||$5,370|
Amortization Sample - Straight-Line Depreciation Method
Your manufacturing facility secures a patent for $15,000 set to expire in five years. To calculate amortization, use the following formula:
Purchase value / useful life
$15,000 / 5 = $3,000 annual amortization expense
Over the next five years, you will write off $3,000 each year to cover the cost of this patent.