Amortization and depreciation affect nearly every business. In a nutshell, these two important accounting concepts are used to spread the cost of intangible and fixed assets over their useful life. But what exactly does that mean in plain English (and how does it impact your bottom line)?
Even if you pay for a fixed or intangible asset in full when you first acquire it, it’s likely you won’t use up the asset in the same year it’s purchased (and chances are it will provide value in the years to come).
Instead, you will use amortization or depreciation to account for a portion of the cost of the asset over a number of years. In other words, amortization and depreciation help tie the cost of an asset directly to the benefit that’s gained by the asset.
Though the terms amortization and depreciation are often used interchangeably, there are several key differences that small business owners should be aware of.
In this guide, we’ll discuss the basics behind amortization and depreciation, how each method differs, and share some real-world examples.
Fixed assets vs tangible assets
First and foremost, let’s go over some common assets that most business owners probably have familiarity with.
A fixed asset, also known as a tangible asset, is a resource that is expected to last for more than one year (and, in the literal sense, typically has some shape, form, and is physical in nature).
- Automobiles, equipment, and buildings are all examples of fixed assets.
On the other hand, an intangible asset is also expected to last more than one year, but – unlike fixed assets – intangible assets, which are not physical in nature, can sometimes accrue value over time.
- Trademarks, copyrights, and patents fall into the category of intangible assets.
Now that we know what intangible and tangible assets are, let’s talk more about how amortization and depreciation are used 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. We should point out that it’s common to mix up the amortization of an intangible asset with an amortization schedule, which figures out mortgage loan payments over a period of time. These two uses of the word “amortization” relate to very different things.
Amortization is similar to depreciation in that it’s used to spread the cost of an asset over a period of time. However, the key difference to remember is that amortization is only used for intangible assets, whereas depreciation is usually only applied to tangible, fixed assets.
Let’s take a moment to discuss depreciation and what it’s used for.
What is the definition of depreciation?
Depreciation is the process of allocating the cost of a tangible — or fixed — asset over the period of time it will be used in a business. Unlike amortization, which has six possible calculations, depreciation is calculated using one of only four 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 many assets to be fully depreciated in the same year that they are purchased. There can be a tax advantage to this, but it might create a difference between the financial reports you use to run your business (and your tax return).
For example, let’s say you had a profitable year in 2022. When your bookkeeper reconciled the books, your net profit — or bottom line — was $100,000.
That said, you also purchased a piece of equipment for $50,000 on January 2, 2022, and the expectation is that this new addition is going to last for the next 10 years. When your bookkeeper recorded the purchase, they posted the $50,000 acquisition to fixed assets on your company’s balance sheet, which means that no part of it is currently impacting your company’s net profit.
In order 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). To do this, your bean counter divides the cost of the piece of equipment by the number of years it is expected to last. Here’s how the equation looks:
(Equipment cost) $50,000 / (Expected life) 10 years = $5,000/year
Following that, your number cruncher then deducts $5,000 from the cost of the equipment for 2022. This brings your net profit down to $95,000, which is not that significant of a difference.
You then turn over the books to your accountant, who will prepare your tax return. Immediately, your tax professional sees you have a large net profit — and in all likelihood — not looking forward to paying taxes on $100,000. To soften the blow, they fully depreciate 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:
- One used for your internal bookkeeping and management reports – $5,000
- One your accountant used for your tax return – $50,000.
So, which one is correct? The answer: Both of them.
It might be surprising to hear, but it’s appropriate for your bookkeeper to use one depreciation calculation for management purposes and for your accountant to use a different calculation for tax purposes. By spreading the cost over several years, your bookkeeper’s records will better match the cost of the asset with the revenue it generates. The results?
- Your bookkeeper’s calculation shows the actual one-year cost of the asset to your company, based on the asset’s useful life.
- Your accountant’s calculation saves you from paying taxes on your full profit for the year.
With a general overview of amortization and depreciation under our belts, it’s time to learn about how these concepts differ from one another.
Key items (and differences) to consider about amortization vs. depreciation
One of the key differences between amortization and depreciation is how the asset’s cost is spread over time. With amortization, even though there are six acceptable calculation methods to choose from, the cost is usually spread evenly over the useful life of the asset.
For example, let’s say a business acquires a patent for $100,000 and its useful life is expected to be a total of 10 years. In this case, the business would amortize the cost of the patent by expensing $10,000 per year for 10 years, which is similar to the straight-line depreciation example discussed above.
Depreciation, on the other hand, is often calculated using a variety of methods. Straight-line depreciation is the most commonly used, and it spreads the cost of the asset evenly over its useful life, as in the example above. That said, there are other methods of depreciation that are frequently used.
When we start talking about the assets that are affected, amortization and depreciation really start to differentiate themselves. As mentioned above, amortization is exclusively applied to intangible assets, such as
- Intellectual property
- Franchise agreements
- Organization costs
Once an asset is fully amortized, there’s typically no resale or salvage value of the asset.
Depreciation is different as it can apply to either tangible (fixed) or intangible assets, but it typically applies to fixed assets, such as
- Office furniture
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 that you purchase a $50,000 piece of equipment to manufacture branded coffee mugs. The particular model you buy is expected 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 2022, your machine produced 4,500 branded coffee mugs. Instead of the $5,000 depreciation your bookkeeper recorded, your depreciation expense would be $4,500,
But, in 2023, your company gets featured on a small business podcast. Demand goes through the roof, the machine is put to the test, and it produces a whopping 15,000 mugs. Now your depreciation expense is $15,000 as opposed to the $5,000 that would have been 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 2023 ($50,000 – $5,000 depreciation in 2022 – $5,000 depreciation in 2023), in reality, it only has $30,500 in useful value ($50,000 – $4,500 depreciation in 2022 – $15,000 depreciation in 2023).
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, let’s also say that you sold each one that you produced. That means in 2022 your company had $13,500 in sales, and in 2023 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 in 2022 was $8,500 ($13,500 in sales – $5,000 depreciation cost of your machine) and $40,000 in 2023 ($45,000 in sales – $5,000 depreciation cost.)
This would imply your per-unit cost in 2022 was $1.89 ($8,500 / 4,500 branded coffee mugs) and $2.67 in 2023 ($40,000 / 15,000 mugs) This doesn’t make sense; your cost per coffee cup should be the same year over year.
In other words, choosing the correct form of depreciation also allows you to tie costs to revenues, which in turn 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.
|Straight-line depreciation ($50,000 / 10 years) Depreciation expense||Ending book value each year||Units of production||Depreciation expense||Ending book value each year|
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 purchased 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 remains the same, regardless of whether you produce 100 gallons or 100,000 gallons of the motor oil.
Using straight-line amortization, your bookkeeper will post $10,000/year in amortization expense for each year you have exclusive use of the patent ($100,000 / 10 years.)
Let’s talk briefly about a difference between the two ideas that is easy to get mixed up.
Understanding amortization vs. depreciation
The most common slipup business owners make when choosing between amortization and depreciation is one of semantics: they use the terms amortization and depreciation interchangeably. However, this is usually a matter of nuance because the impact on the company’s financial statements is the same regardless of the term used.
Where a bigger (and more costly) challenge can arise is if a business owner chooses the wrong type of depreciation for an asset. This is why it’s a best practice to work with your accountant to make sure you are depreciating your assets correctly.
It’s important to note, though, that not every asset can be depreciated or amortized.
- Land is the most common example of a fixed asset where depreciation is not an option. From an accounting perspective, land never loses its value.
- Investments such as stocks, bonds, and collectibles are also non-depreciable. You will 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, cannot be depreciated. Instead, you record the lease payments as expenses on your profit and loss statement.
We’ve covered a lot of ground, but as we move on (and begin to wrap up), we touch on the different methods of amortization and depreciation below.
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 are methods that allocate more of the cost of the asset to the early years of its useful life. The logic behind these methods is that assets lose value more quickly in the early years of their useful life (similar to a brand new car losing value the moment it’s driven off a lot). When using these methods, there is often a larger final-year depreciation expense recorded, which can be 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 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. Depreciation Rate is simply 1 / Useful Life. For our branded mug machine, that would be 0.10, or 10% (1 / 10 years).
So, in 2022, the depreciation using declining balance depreciation would be
$50,000 x 10% = $5,000
In 2023, you would subtract the $5,000 already depreciated from the starting book value of $5,000, and your depreciation would be
$45,000 x 10% = $4,500
And so on.
Double-declining balance depreciation is similar, but the depreciation occurs faster. So, in 2022, your depreciation would be
2 x $50,000 x 10% = $10,000
And in 2023 it would be
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 it’s used less frequently than declining balance depreciation. In sum-of-the-years’ digits (SYD) depreciation, you begin by combining all the digits of the useful life of the asset.
Let’s say that you decide to use SYD depreciation for your branded coffee mug machine. You’ll start by combining the digits of the expected life of the machine
1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55
Then, you would divide the useful life of the machine (10 years) by the sum of the years
In 2022 – Year One – you would depreciate 10/55 of the book value, or depreciable base, of your machine
10/55 x $50,000 = $9,091
In 2023 – Year Two – you would depreciate 9/15 of the depreciable base
9/55 x ($50,000 – $9,091) = $6,694
And you would continue using this method until year 10, when 1/55 of the book value is depreciated and the book value becomes zero.
The following table outlines how the depreciation of your branded coffee mug machine would look using each of these accelerated depreciation methods.
|Declining balance depreciation expense||Ending book value each year||Double-declining balance depreciation expense||Ending book value each year||Sum-of-the-years-digits depreciation expense||Ending book value each year|
To tie everything together, let’s go over the various methods of amortization (and what’s commonly used).
What are the methods of amortization?
The six methods of amortization are
- Declining balance
- Negative amortization
Of these six methods, only straight-line amortization is commonly used. The calculation is identical to straight-line depreciation.
Furthermore, for tax purposes, only two types of amortization may be used. One of these is straight-line amortization. The other is called “income forecast” amortization and is used exclusively for motion pictures, videotapes, sound recordings, copyrights, books, or patents.
Amortization and depreciation affect most businesses
At the end of the day, depreciation and amortization are two crucial accounting concepts that are used to spread an asset’s cost over its useful life and can help a business make smarter decisions. Though they won’t have an effect on your company’s cash flow, they can be used to paint a bigger picture about the cost of doing business. While these two terms are often used interchangeably, it is important to understand the difference between the two.
If you are unsure about the right path for your needs, it can be a good idea to speak with your accountant to choose the best depreciation method for each asset in your business, keeping in mind that they might initially steer you toward tax depreciation as opposed to book depreciation. No matter which method you decide to use, best of luck as you move your organization forward.