Amortization allocates the cost of intangible assets or certain prepaid expenses over multiple years while depreciation allocates the cost of tangible assets with physical substance over their estimated useful life. Essentially, they are similar concepts in that they both involve the gradual allocation of the cost of assets over time. They help businesses reflect the cost of assets on their financial statements accurately and avoid showing a large expense upfront, which can distort profitability.
Examples of Amortization vs Depreciation
Amortization
Let’s say a company spends $20,000 to develop a new software program that it expects to be commercially viable for five years. This program is considered an intangible asset. Since it has a limited useful life, the company can’t just expense the entire $20,000 in the year it was developed—this wouldn’t accurately reflect the software’s impact on the company’s finances over time.
Instead, the company will amortize the cost of the program over its five-year useful life. This means that it will record an expense of $4,000 per year (spreading the $20,000 cost evenly over five years) on its income statement. This $4,000 expense is called amortization expense.
By amortizing the program, the company spreads the cost out over the period it benefits from the asset, thus matching the cost of the software with the revenue that it will generate.
Depreciation
Say a company purchases machinery for its manufacturing operations. The machinery costs $100,000 and is expected to have a useful life of 10 years, with no salvage value at the end of its life.
Using the straight-line depreciation method, the company would allocate the cost of machinery evenly over its useful life. The formula is:
In this case, the calculation would be:
Depreciation Expense per Year = ($100,000 – $0) ÷ 10 years
= $10,000 per year
So, each year, the company would record a depreciation expense of $10,000 for the machinery on its income statement. This expense represents the portion of the machinery’s cost that is being “used up” or consumed each year in the manufacturing process.
Over the 10-year period, the accumulated depreciation would total $100,000. This would match the original cost of the machinery, effectively reducing its book value to zero by the end of its useful life.
Straight-line depreciation with no salvage value is essentially the same calculation as amortization expense. However, depreciation can be calculated in a number of different ways—such as double-declining balance, sum-of-the-years-digits, and units of production. Amortization doesn’t generally have this flexibility. For more information, read our guide on how depreciation works.
Common Use Cases of Amortization vs Depreciation
- Software costs: Companies often amortize the cost of purchased software licenses or development costs over the expected useful life of the software. This allows them to match the expense of the software to the revenue it generates over time.
- Intangible asset expenses: Businesses use amortization in accounting to spread the cost of intangible assets, like patents, copyrights, or trademarks, over their useful life. Unlike physical assets that wear out, intangible assets have a limited value life.
- Lease expenses: Operating lease expenses are often amortized evenly over the lease term. This ensures that the expense of using an asset is spread out evenly over the time the asset is in use.
- Loan costs: Costs of obtaining a loan—such as points paid to reduce the interest rate—are generally amortized over the life of the loan.
- Fixed assets: Businesses use depreciation to allocate the cost of fixed assets—such as buildings, machinery, vehicles, and equipment—over their useful lives. This helps match the expense of acquiring these assets with the revenue they generate over time.
- Asset management: Depreciation helps businesses track the age of their assets and plan for replacements or upgrades as they near the end of their useful lives. This is crucial for maintaining operational efficiency and avoiding unexpected downtime due to equipment failure.
- Investment analysis: Depreciation impacts financial metrics such as net income, operating income, and cash flow. Analysts use depreciation figures to assess a company’s financial performance, evaluate investment opportunities, and compare the profitability of different projects or assets.
- Cost allocation: By spreading the value of an asset over its useful life, depreciation ensures that the expense is allocated to the accounting periods in which the asset is used to generate revenue. This provides a more accurate representation of a company’s profitability over time.
Learn four things you need to know about fixed asset accounting to learn how to account for fixed assets.
Balance Sheet Impact of Amortization vs Depreciation
While both amortization and depreciation involve the allocation of the cost of assets over time, they differ in terms of the types of assets they apply to and the specific accounting treatment. Following is a comparison of how they each impact a company’s balance sheet.
Amortization
The balance sheet impact of amortization depends on the type of asset being amortized. Amortization typically applies to intangible assets or certain prepaid expenses. Here’s how it affects the balance sheet:
- Intangible assets: When an intangible asset is amortized, its value decreases over time on the balance sheet. This decrease is reflected in the asset’s carrying value, reducing it gradually until the asset is fully amortized. The corresponding entry is a debit to Amortization Expense (an income statement account) and a credit to Accumulated Amortization (a contra-asset account, deducted from intangible asset’s original cost).
- Prepaid expenses: Prepaid expenses, such as prepaid rent or insurance premiums, are initially recorded as assets on the balance sheet because they represent future economic benefits. As these benefits are consumed or utilized, the prepaid expense is gradually recognized as an expense on the income statement through amortization. The balance sheet impact of amortization in this case is a reduction in the prepaid expense asset and a corresponding increase in the related expense on the income statement.
In both cases, the net impact of amortization on the balance is a decrease in the carrying value of the asset being amortized. This reduction reflects the allocation of the asset’s cost over its useful life to match the expense with the periods in which it provides benefits. Accumulated amortization serves to show the total amount of amortization expense recognized since the asset was acquired, providing transparency about the asset’s remaining value.
Depreciation
Depreciation primarily impacts the balance sheet through its effect on the carrying value of tangible assets. Here’s how depreciation affects the balance sheet:
- Tangible assets: Buildings, machinery, equipment, vehicles, and other intangible assets are initially recorded on the balance sheet at their cost. As these assets are used over time, they lose value due to wear and tear, obsolescence, or other factors. Depreciation is the accounting method used to allocate the cost of these assets over their estimated useful lives.
- Each accounting period a portion of the asset’s cost is recognized as depreciation expense on the income statement.
- Simultaneously, the accumulated depreciation account on the balance sheet increases by the same amount. Accumulated depreciation is a contra-asset account, which reduces the carrying value of the asset.
- The carrying value of the asset on the balance is calculated as its historical cost minus accumulated depreciation. This reflects the portion of the asset’s original cost that has been allocated as an expense over time.
- Net book value: Also known as net carrying amount or net carrying value, the net book value of tangible assets on the balance sheet is the difference between the asset’s historical cost and its accumulated depreciation. This represents the remaining value of the asset that has not yet been allocated as an expense through depreciation.
- Impact on equity: The reduction in the carrying value of assets due to depreciation directly affects equity on the balance sheet. Since equity is equal to assets minus liabilities, a decrease in asset value (due to accumulated depreciation) results in a corresponding decrease in equity.
In summary, depreciation reduces the carrying value of tangible assets on the balance sheet by recognizing a portion of their cost as an expense over time. This ensures that the asset’s value is appropriately matched with the revenue it helps generate and provides a more accurate representation of the asset’s remaining value.
Frequently Asked Questions (FAQs)
The difference between depreciation vs amortization is that depreciation allocates the cost of tangible assets, while amortization focuses on intangible assets and their useful life. Both are accounting methods that allocate the cost of an asset over its expected useful life.
Amortization is specifically used for intangible assets—or assets that are nonphysical but hold value for a business. Common types of assets that undergo amortization include intellectual property, licenses, goodwill, mailing lists, and customer relationships.
The main objectives of both are to match the cost of purchasing assets with the revenues they generate over multiple years and to provide a more accurate representation of a company’s financial position and performance over time.
No, amortization is a noncash expense, meaning it doesn’t involve a direct cash outflow.
Bottom Line
The difference between depreciation vs amortization is that depreciation applies to tangible assets and represents the allocation of their cost over time due to physical wear and tear, whereas amortization applies to intangible assets and represents the allocation of their cost over time due to their useful life. Both practices help match expenses with the revenues generated by the use of these assets, providing a more accurate representation of a company’s financial performance.