Difference Between Depreciation and Amortization

Every organization invests in fixed or immobilized assets. Over time, durable assets (mobile phones, machinery, trucks, etc.) lose value. In other words, they suffer an amortization or depreciation. Sometimes, we use the terms depreciation and amortization interchangeably, and in accounting, they have a similar but not the same concept. In this article, we will clarify the difference between amortization and depreciation. Learn what depreciation and amortization are. Explore the difference between depreciation and amortization.

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Comparison Table – Depreciation vs. Amortization

Both terms imply the reduction in the value of an asset. The main difference between amortization and depreciation is that amortization is related to intangible assets and deferred expenses, while depreciation is directly related to fixed assets. 

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What is Depreciation?

Depreciation refers to the decrease in the value of a tangible fixed asset, such as machinery or a building, due to use, wear and tear, and obsolescence. Depreciation is recorded as an expense on the income statement and is used to reduce the asset's book value on the balance sheet.

Some examples of fixed or tangible assets that are usually depreciated are:

• Buildings
• Equipment
• Office furniture
• Vehicles
• Machinery

What are the Types of Depreciation?

Man types of depreciation methods are – 

Straight Line Depreciation: In the straight-line depreciation method, depreciation is considered in terms of time span and asset consumption/use. It is a simple method and applies the same amount of depreciation each year the value of the assets depletes.

Declining Balance Depreciation: The declining balance depreciation method depreciates the asset at a higher rate in the early years of its life and reduces the depreciation rate over time. This reflects that assets lose value more quickly in their early years of use.

Annual Depreciation: In the annual depreciation method, the scrap cost is lowered each year. The values of assets gradually decrease. 

Depreciation of Production Units: In this method, the asset's value is divided by the number of units it can produce during its entire useful life.

Accelerated Depreciation: Accelerated depreciation will be understood as that whose objective is to increase the annual quota of depreciation of the fixed assets of the company in such a way that the years of useful life are reduced to a third.

Double Declining Balance Depreciation: This is an accelerated depreciation method that doubles the declining balance method’s depreciation rate. The double declining balance depreciation method is useful for assets that lose value in the early years of their life.

What is Amortization?

Amortization refers to a decrease in the value of an intangible asset, such as a patent or trademark, due to the expiration of time or use. Like depreciation, amortization is recorded as an expense on the income statement and is used to reduce the asset's book value on the balance sheet.

Examples of intangible assets that are expensed through amortization include

• Patents and Trademarks
• Franchise agreements
• Proprietary processes, such as copyrights
• Cost of issuing bonds to raise capital
• Organizational costs

Types of Amortization

Straight-line amortization: In this type of amortization, the borrower makes equal payments over the life of the loan. The payment includes both interest and principal amounts. Here the amount of interest decreases with the payment of the loan balance.

Balloon payment amortization: Balloon payment amortization involves paying off smaller amounts over the life of the loan, and then followed by a large payment, also known as a “balloon” payment at the end. Balloon payment amortization is a popular method to pay off loans in mortgages or other long-term loans. This allows borrowers to keep their monthly payments lower.

Negative amortization: Negative amortization refers to a situation when the borrower’s payments are insufficient to cover the loan interests, which is why the unpaid interest is added to the loan balance, leading to a growing loan balance.

Interest-only amortization: In this type of amortization method, the borrower only pays the loan interest for an agreed-upon period and then pays the principal amount. This can be a good option for borrowers who expect an increased income in the future.

Accelerated amortization: In accelerated amortization, the borrower pays larger payments than required with an aim to pay off the loan more quickly. This way they can save the interest over the life of the loan.

Key Takeaways

• Amortization and depreciation are two methods of calculating the value of a company’s assets over time.
• A business calculates these expenses to reduce its tax liability.
• Amortization is the practice of spreading the cost of an intangible asset over its useful life.
• Depreciation is the cost of a fixed asset over its useful life.

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