Amortization vs. depreciation: What’s the difference?

Tangible assets vs. intangible assets

First, let’s go over some common types of assets most business owners are familiar with.

A fixed asset, also known as a tangible asset, is a physical resource expected to last more than one year. Automobiles, equipment, and buildings are all examples of fixed assets.

An intangible asset is also expected to last more than one year, but unlike fixed assets, it has no physical form. Trademarks, copyrights, and patents are examples of intangible assets.

Now that we know what tangible and intangible assets are, let’s talk about how to use amortization and depreciation to account for each.

What is the definition of amortization?

In its simplest terms, amortization refers to the process of spreading the cost of an intangible asset over its useful life. It’s common to mix this up with a loan amortization schedule, which calculates mortgage and other loan payments over time. These are two different uses of the same word.

Amortization is similar to depreciation in that both spread the cost of an asset over a period of time. The key difference is amortization applies only to intangible assets, while depreciation is usually only applied to tangible, fixed assets.

Let’s take a moment to discuss depreciation and how you use it.

What is the definition of depreciation?

Depreciation is the process of allocating the cost of a tangible — or fixed — asset over the period you use it in your business. Unlike amortization, which has six possible calculations, depreciation has only four calculation methods. These are:

• straight-line depreciation
• declining balance depreciation
• units of production depreciation
• sum-of-the-years’ digits depreciation.

Tax vs. book depreciation and amortization

The US tax code allows businesses to fully depreciate many assets in the year they’re purchased. This can create a tax advantage, but it might also a difference between the financial reports you use to run your business and the numbers on your tax return.

For example, let’s say you have a profitable Year One. When your bookkeeper reconciles the books, your net profit, or bottom line, is $100,000.

That same year, you purchase a piece of equipment for $50,000 on January 2, and you expect it to last for the next 10 years. When your bookkeeper records the purchase, they post the $50,000 acquisition to fixed assets on your company’s balance sheet, so no part of it currently impacts your net profit.

To recognize the current year’s cost of the equipment on your profit and loss statement, your bookkeeper uses straight-line depreciation (more on this later in the article). They divide the cost of the equipment by the number of years you expect it to last. Here’s how the equation looks:

• $50,000 equipment cost / 10 year expected life = $5,000/year

Your bookkeeper then deducts $5,000 from the cost of the equipment for Year One. This brings your net profit down to $95,000, which isn’t a significant difference.

You then turn over the books to your accountant to prepare your tax return. Seeing your large net profit, your accountant uses bonus depreciation or Section 179 expensing to write off 100% of the cost of the equipment for tax purposes. On your tax return, they deduct $50,000 in depreciation from your $100,000 net profit, giving you a taxable profit of $50,000.

Now you have two different depreciation calculations:

• Bookkeeping and management reports: $5,000 using straight-line depreciation
• Tax return: $50,000, using accelerated depreciation

Both are correct. It might be surprising to hear, but it’s common for your bookkeeper to use one depreciation calculation for management purposes and for your accountant to use a different calculation for tax planning. By spreading the cost over several years, your bookkeeper’s records better match the asset’s cost to the revenue it generates.

As a result, your bookkeeper’s calculation shows the actual one-year cost of the asset to your company, based on the asset’s useful life. Your tax accountant’s calculation saves you from paying taxes on your full profit for the year.

With that overview of amortization and depreciation, let’s look at how the two concepts differ.

Key items (and differences) to consider about amortization vs. depreciation

One of the key differences between amortization and depreciation is how it spreads the asset’s cost over time. With amortization, even though there are six acceptable calculation methods to choose from, you usually spread the cost evenly over the asset’s useful life.

For example, let’s say a business acquires a patent for $100,000 and its useful life is expected to be 10 years. In this case, the business amortizes the cost of the patent by expensing $10,000 per year for 10 years, similar to the straight-line depreciation example discussed above.

You can calculate depreciation, on the other hand, using a variety of methods. Straight-line depreciation is the most commonly used. It spreads the cost of the asset evenly over its useful life, as in the example above. But there are other methods of depreciation.

Amortization and depreciation also differ in why the underlying asset loses value. Intangible assets lose value through legal or economic expiration, such as a patent’s protection running out or a franchise agreement ending, rather than through use. Tangible assets, on the other hand, lose value primarily through physical wear and tear, or obsolescence as newer equipment or technology becomes available.

The two methods also differ in which type of assets they apply to. Amortization applies to intangible assets, such as:

• Patents
• Trademarks
• Copyrights
• Goodwill
• Intellectual property
• Franchise agreements
• Organization costs

Once you fully amortize an asset, there’s typically no resale or salvage value.

Depreciation differs because it can apply to either tangible (fixed) or intangible assets, but it typically applies to fixed assets, such as:

• Vehicles
• Buildings
• Equipment
• Office furniture
• Computers

Software is an example of an intangible asset that can be depreciated instead of amortized. Unlike a fully amortized intangible asset, a fully depreciated fixed asset often does have a resale or salvage value.

What is an example of depreciation?

We briefly touched on one depreciation example above, but let’s take a deeper dive, this time using a different depreciation method.

Let’s say you purchase a $50,000 piece of equipment to manufacture branded coffee mugs. You expect the model you buy to produce 50,000 mugs during its useful life.

Because it’s easy to track how many units the device turns out, you decide to use “units of production” depreciation. The math is easy to wrap your head around, too: Each mug produced costs $1. ($50,000 purchase price / 50,000 mugs = $1/mug).

Now, let’s say in Year One, your machine produces 4,500 branded coffee mugs. Instead of the $5,000 depreciation your bookkeeper would record using straight-line depreciation, your depreciation expense is $4,500.

But in Year Two, your company gets featured on a small business podcast. Demand goes through the roof, the machine runs at full capacity, and it produces a whopping 15,000 mugs. Now your depreciation expense is $15,000 compared to the $5,000 you’d have booked using straight-line depreciation.

This example shows why it’s so important to choose the correct depreciation method for each asset your business owns. Whereas straight-line depreciation would lead you to believe that the equipment still has $40,000 in useful value at the end of Year Two ($50,000 – $5,000 depreciation in Year One – $5,000 depreciation in Year Two), in reality, it only has $30,500 in useful value ($50,000 – $4,500 depreciation in Year One – $15,000 depreciation in Year Two).

Another way to look at depreciation is as a cost of production. Let’s say you sell these mugs for $3 each. To keep the math simple, you sell every one you produce. That means in Year One your company has $13,500 in sales, and in Year Two you have $45,000 in sales.

Using straight-line depreciation for your machinery would lead you to believe that your gross profit on coffee mugs was $8,500 in Year One ($13,500 in sales – $5,000 depreciation cost of your machine) and $40,000 in Year Two ($45,000 in sales – $5,000 depreciation cost.)

This implies your per-unit cost was $1.89 in Year One ($8,500 / 4,500 branded coffee mugs) and $2.67 in Year Two ($40,000 / 15,000 mugs). That doesn’t make sense; your cost per mug should be the same year over year.

In other words, choosing the correct form of depreciation ties costs to revenues, which gives you better insight into your profitability.

The following table outlines how the depreciation of the equipment might look from both a straight-line and a units of production depreciation perspective.

Notice in this example, your branded coffee mug maker is fully depreciated after five years using units of production depreciation, as opposed to 10 years using straight-line depreciation.

After going over depreciation in more detail, let’s look at an example of amortization.

What is an example of amortization?

Even though there are six possible ways to calculate amortization, most people only use the straight-line method. That’s because, unlike tangible assets, the useful life of an intangible asset typically isn’t impacted by use, meaning there’s no wear and tear.

Let’s say you purchase a patent for $100,000. This patent allows your business to use proprietary information, like a formula for a specific type of motor oil, for 10 years. In this example, the usefulness of the patent stays the same regardless of whether you produce 100 gallons or 100,000 gallons of motor oil.

Using straight-line amortization, your bookkeeper posts $10,000 per year in amortization expense for each year you have exclusive use of the patent ($100,000 / 10 years.)

Next, let’s clear up a common point of confusion about the difference between amortization and depreciation.

Understanding amortization vs. depreciation

The most common slipup business owners make when choosing between amortization and depreciation is a matter of semantics: using the terms interchangeably. This is a minor issue, since the impact on your financial statements is the same regardless of which term you use.

A bigger (and costlier)  problem arises when a business owner chooses the wrong type of depreciation for an asset. This is why it’s best practice to work with your accountant to make sure you depreciate assets correctly.

Not every asset can be depreciated or amortized:

• Land: This is the most common example of a fixed asset where depreciation isn’t an option. From an accounting perspective, land never loses its value.
• Investments: Stocks, bonds, and collectibles are also non-depreciable. You record a gain or a loss on the sale of these assets, but they don’t lose value over time from an accounting perspective.
• Leased assets: Whether vehicles or buildings, you can’t depreciate leased assets. Instead, you record the lease payments as expenses on your profit and loss statement.

We’ve covered a lot of ground. Next, let’s look at the different methods of amortization and depreciation.

What are the methods of depreciation?

There are four accepted methods of depreciation, and we’ve taken an in-depth look at straight-line and units of production depreciation already. Though the other two methods are used less frequently, they are still important to understand.

Declining balance and double-declining balance depreciation allocate more of the asset’s cost to the early years of its useful life. The logic behind these methods is that assets lose value more quickly early on, similar to how a new car loses value the moment it leaves the lot). When using these methods, you often record a larger depreciation expense in the final year, which you can offset by declaring a salvage value for the asset.

To visualize, the declining balance depreciation formula is:

• (Book Value – Salvage Value) x Depreciation Rate

And the double-declining balance depreciation formula is:

• 2 x (Book Value – Salvage Value) x Depreciation Rate

Going back to your branded coffee mug machine, we already know the starting book value ($50,000) and the useful life (10 years) from when we applied straight-line depreciation to it. For the sake of simplicity, let’s assume you apply no salvage value to your machine.

This leaves us to calculate depreciation rate, which is 1 / useful Life. For our branded mug machine, that’s 0.10, or 10% (1 / 10 years).

So, in Year One, your depreciation using declining balance depreciation is:

• $50,000 x 10% = $5,000

In Year Two, you subtract the $5,000 already depreciated from the starting book value of $50,000, and your depreciation is:

• $45,000 x 10% = $4,500

And so on.

Double-declining balance depreciation works the same way, but the depreciation occurs faster. In Year One, your depreciation is:

• 2 x $50,000 x 10% = $10,000

And in Year Two, it is:

• 2 x ($50,000 – $10,000) x 10% = $8,000

And so on.

Double-declining balance depreciation works the same way, but the depreciation occurs faster. In Year One, your depreciation is:

• 2 x $50,000 x 10% = $10,000

And in Year Two, it is:

• 2 x ($50,000 – $10,000) x 10% = $8,000

And so on.

Sum-of-the-years’ digits depreciation is, like declining balance and double-declining balance depreciation, an accelerated depreciation method, but businesses use it less frequently than declining balance depreciation. In sum-of-the-years’ digits (SYD) depreciation, you begin by combining all the digits of the asset’s useful life.

Let’s say that you decide to use SYD depreciation for your branded coffee mug machine. You start by combining the digits of the machine’s expected life:

• 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55

Then, you divide the useful life of the machine (10 years) by the sum of the years:

• 10/55

In Year One, you depreciate 10/55 of the book value, or depreciable base, of your machine:

• 10/55 x $50,000 = $9,091

In Year Two, you depreciate 9/55 of the depreciable base:

• 9/55 x ($50,000 – $9,091) = $6,694

You continue using this method until Year Ten, when the final 1/55 of the book value is depreciated and the book value reaches zero.

The following table outlines how the depreciation of your branded coffee mug machine would look using each of these accelerated depreciation methods.

To tie everything together, let’s go over the various methods of amortization and what business owners commonly use.

What are the methods of amortization?

The six methods of amortization are:

• Straight-line
• Declining balance
• Annuity
• Bullet
• Balloon
• Negative amortization

Of these six methods, businesses typically only use straight-line amortization. The calculation is identical to straight-line depreciation. For tax purposes, the IRS only allows two types of amortization. One is straight-line amortization. The other is called the “income forecast” method, used exclusively for motion pictures, videotapes, sound recordings, copyrights, books, and patents.