For those business assets, amortization and depreciation are two methods of calculating value. Each year over the life of the asset, the cost of business assets can be expensed. To reduce the tax liability for the business, the expense amounts are subsequently used as a tax deduction. Amortization, depreciation, and one more common method used by businesses to spread out the cost of an asset will be reviewed in this article. The involvement of a type of asset being expensed is the key difference between all three methods.
The practice of spreading an intangible asset’s cost over that asset’s useful life is called amortization. Physical assets are not intangible assets, per se. Intangible assets that are expensed through amortization might include the following examples:
- Patents and trademarks
- Franchise agreements
- Proprietary process, such as copyrights
- Cost of issuing bonds to raise capital
- Organizational costs
Amortization is physically expensed on a straight-line basis, meaning the same amount is expensed in each period over the asset’s useful life, unlike depreciation. Additionally, unlike with depreciation, assets that are expensed using the amortization method typically don’t have any resale or salvage value.
When using the term amortization since it carries another meaning, it is important to note the context. As in the case of a mortgage, to calculate a series of loan payments consisting of both principal and interest in each payment, an amortization schedule is often used.
The expense of a fixed asset over its useful life is called depreciation. Physical assets that can be touched are fixed assets or tangible assets. Fixed or tangible assets that are commonly depreciated includes some of these examples.
- Office furniture
Depreciation is calculated by subtracting the asset’s salvage value or resale value from its original cost since tangible assets might have some value at the end of their life. The expected life of the asset over the years is when depreciation is evenly different. In other words, a tax reduction for the company until the useful life of the asset has expired for the depreciated amount of expensed in each year.
An example, an office building can be used for many years before it becomes run down and is sold. With a portion of the cost being expensed in each accounting year, the cost of the building is spread out over the predicted life of the building.
A large portion of the asset’s value is expensed in the early years if the asset’s life, meaning the depreciation of some fixed assets can be done on an accelerated basis.
Another way the cost of business assets can be established is by depletion. the allocation of the cost of natural resources over time is what it refers to. All three methods are a non-cash expense with no cash spent in the years they are expensed—depreciation, amortization, and depletion. The terms amortization and depreciation are often used interchangeably in other countries to refer to both tangible and intangible assets, which is an important thing to note.