Amortization vs. Depreciation: An Overview
Amortization and depreciation are the two main methods of calculating the value of these assets. There’s a third, less commonly used, method: depletion.
The key differences between the three methods involve the type of asset being expensed.
- Amortization and depreciation are two methods of calculating the value for business assets over time.
- A business will calculate these expense amounts in order to use them as a tax deduction and reduce its tax liability.
- Amortization is the practice of spreading an intangible asset’s cost over that asset’s useful life.
- Depreciation is the expensing of a fixed asset over its useful life.
- A third method for expensing business assets is the depletion method, which is an accrual accounting method used by businesses that extract natural resources from the earth—such as timber, oil, and minerals.
Amortization is the accounting practice of spreading the cost of an intangible asset over its useful life. Intangible assets are not physical in nature but they are, nonetheless, assets of value.
Examples of intangible assets that are expensed through amortization include:
- Patents and trademarks
- Franchise agreements
- Proprietary processes, such as copyrights
- Costs of issuing bonds to raise capital
- Organizational costs
Amortization is typically expensed on a straight-line basis. That means that the same amount is expensed in each period over the asset’s useful life.
Assets that are expensed using the amortization method typically don’t have any resale or salvage value.
(The term “amortization” is used in another, unrelated, context. An amortization schedule is often used to calculate a series of loan payments consisting of both principal and interest in each payment, as in the case of a mortgage.)
The term amortization is used in both accounting and in lending with completely different definitions and uses.
Some examples of fixed or tangible assets that are commonly depreciated include:
- Office furniture
Unlike intangible assets, tangible assets might have some value when the business no longer has a use for them. For this reason, depreciation is calculated by subtracting the asset’s salvage value or resale value from its original cost. The difference is depreciated evenly over the years of the expected life of the asset.
In other words, the depreciated amount expensed in each year is a tax deduction for the company until the useful life of the asset has expired.
For example, a business may buy or build an office building, and use it for many years. The business then relocates to a newer, bigger building elsewhere. The original office building may be a bit rundown but it still has value. The cost of the building, minus its resale value, is spread out over the predicted life of the building, with a portion of the cost being expensed in each accounting year.
Depreciation of some fixed assets can be done on an accelerated basis, meaning that a larger portion of the asset’s value is expensed in the early years of the asset’s life. Vehicles are typically depreciated on an accelerated basis.
Depletion is another way that the cost of business assets can be established in certain cases. It is relevant only to the valuation of natural resources.
For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well’s setup costs can be spread out over the predicted life of the well.
The two basic forms of depletion allowance are percentage depletion and cost depletion. The percentage depletion method allows a business to assign a fixed percentage of depletion to the gross income received from extracting natural resources. The cost depletion method takes into account the basis of the property, the total recoverable reserves, and the number of units sold.
The Common Factor
With depreciation, amortization, and depletion all are non-cash expenses. That is, no cash is spent in the years for which they are expensed.
In some countries, including Canada, the terms amortization and depreciation are often used interchangeably to refer to tangible and intangible assets.
Correction—Jan. 20, 2022: An earlier version of this article erroneously listed land as an asset that could be depreciated. Land can never be depreciated, according to the IRS.