The business's tax liability can be reduced using the calculated expense amounts. Amortization and depreciation are two primary methods to calculate the asset's value over time. According to the type of asset, one of these two accounting approaches is used.
Differences occur between the calculation methods, elements in the calculation, and their presentation on the financial statement.
Want to get more about amortization vs. depreciation? Keep reading and get information about amortization vs. depreciation, calculation method, and the fundamental differences between the two. You will also learn how gini will help you accurately calculate and present the value of the company's assets on the financial statement.
What is amortization?
Amortization is the accounting approach to calculate the value of an intangible asset and spread it over a specific duration, especially its useful life. Amortization takes place for the same amount of assets for each financial year and is calculated straight-line.
Amortization is necessary to forecast the future value of businesses and investors. Amortized expenses greatly influence a company's balance sheet, income statement, and tax liability. In loan payments or tax purposes, amortization is helpful to indicate and clarify the interest vs. principal amount.
Amortization also has another meaning and is used for calculating the number of loan payments. This series of loan payments have both principal and interest for every payment, such as the mortgage. An amortization schedule is calculated for a loan which is also an intangible asset, and so do the amortization method.
Amortization of a loan
Amortization of a loan is the continuous process of paying the total loan amount over a set period. An outset with the series of loan payments is built at the time of loan taking. Afterward, the individual or the company is responsible for paying back the balance on time with each fixed payment.
Loan payments have fixed payments for each month or installment. But the principal and interest taken on the loan will change over time. It is usually more in the beginning and will reduce as the months pass. Loan amortization is essential in the consumer and business world as it indicates how to divide the payments with an appropriate amount of principal and interest.
Amortization of assets
When dealing with assets, amortization performs a different task. It calculates the value of intangible assets over time. It is difficult to calculate the value of those assets with no fixed value and true cost.
Amortization enables you to count your gradual losses and then match the expense and annual revenue amount.
What is an example of amortization?
Amortization is essential for the management of loan principles and intangible assets. Let's see the following examples of amortization.
The initial cost of a patent for a machine is $10,000, which will last ten years. The amortization expense over the patent should be $1,000 per year. ($10,000/10 years)
You have a loan of about $10,000. If you pay the principal amount of $2,000 yearly, the amortized loan should be $2,000. You should put $2,000 as the amortization expense in your record book.
What assets are amortized?
The process of determining the true capital value and intangible assets is a challenging task. Market factors or limiting factors like regulatory issues can reduce an asset's useful or legal life. The amortization method uses intangible assets with an identifiable legal or useful life.
Intangible assets are not physical assets, such as intellectual property and Goodwill, including copyrights, trademarks, patents, and organizational costs. Companies can acquire or create these intangible assets (definite or indefinite) according to their purpose.
A company's intangible assets are presented on its balance sheet under the long-term assets section. While the assets being amortized take place on the company's income statement. Also, a privately held company or business has the exception to calculate and amortize its Goodwill for a long time, usually ten years.
Definite useful assets are amortized, while indefinite assets don't have any recorded book value and presentation over the balance sheet. Amortization usually takes place for assets that have no resale or salvage value.
What is depreciation?
Depreciation is an approach to calculating the value of a fixed asset for its legal or useful life. Fixed assets or physical assets are also known as tangible assets. Some tangible assets, such as equipment, vehicles, buildings, furniture, and machinery, are commonly used for depreciation.
Depreciation is a useful method for recovering the original cost over an asset's life instead of a sudden recovery. It means that they have a great expense value in the beginning. Some fixed assets, like vehicles, are depreciated on an accelerated basis.
With depreciation expense, companies can use enough revenue to replace their upcoming assets. Depreciation allows companies to look deeply at their earnings and determine the tax amount they will have in the future. This will help them reduce the tax amount they owe.
What is an example of depreciation?
As stated earlier, depreciation calculates the useful life of a fixed asset over time. Let's see the following example of depreciation.
- Vehicle depreciation
Suppose a company purchased a vehicle for $100,000 with an expected useful life of about five years. The company should have a yearly accelerated depreciation value of $20,000 for the next five years.
What assets are depreciated?
Companies are not likely to use accelerated depreciation for all their assets. Assets with short-term usage are mostly low-cost, so they count as business expenses. They are recorded in the year company used them. Depreciation applies only to fixed assets; not all fixed assets can depreciate.
Depreciation is applied to tangible items such as Manufacturing machinery, vehicles, office buildings, buildings you rent out for income, and equipment, including computers. Other fixed assets can be depreciated if you are likely to improve their value and expenses and they have a salvage value.
Besides fixed assets, some intangible assets also have some value when they are no longer useful for a company. If this is a reason for an intangible asset, depreciation can take place.
Key differences between amortization and depreciation
Let's look at some important differences between amortization and depreciation.
Amortization is used for intangible assets such as intellectual property, copyrights, and patents that are not physical. At the same time, fixed or physical assets can be depreciated to allocate their legal or useful life.
"Amortize" is the spread of value or cost over a specified period. On the other hand, "Depreciate" is used to diminish the value of something over its life span. Amortization is the record of the value of an asset over a period, while depreciation is calculated to forecast the worth of an asset with its initial cost.
Types of methods
For amortization, companies usually use the straight-line method with the useful lifetime of intangible assets. Meanwhile, several methods are used to depreciate the use of a tangible asset salvage value over a period.
Amortization is a simple method that counts the same expense for an old or new asset. At the same time, with its several methods, depreciation is used in an asset's early years.
The methods and formulas for amortization and depreciation differ based on salvage value. For a depreciation base, the salvage value of a fixed asset is reduced, while for an amortization base, the salvage value of an intangible asset is not reduced. This is because fixed assets or goods may have a residential value, whereas intangible assets do not have a resale or salvage.
How do you calculate amortization and depreciation?
To amortize intangible assets, the straight-line method is used. With this method, companies can spread the cost of their assets with even distribution on all good years of the asset's life.
The amortization formula is:
Capitalized cost = Annual amortization expense / Estimated useful life
For using depreciation, you need to collect some valuable finances of your company. An asset's expected output or useful life, original cost (shipping, taxes, expenses, preparation), and residual value are the main components of depreciating a tangible asset.
Although several depreciation methods are used to calculate the depreciated amount, the three most common ways are:
It is the most common depreciation method with easy processing.
Annual Depreciation Expense = (Asset Cost - Residual Value) / Useful Life of the Asset
Per Unit Depreciation = (Asset Cost - Residual Value) / Useful Life in Units of Production
Total Depreciation Expense = Per Unit Depreciation x Units Produced
Double-declining balance method
2 x basic depreciation rate x book value
Amortization and depreciation help forecast a company's growth with its existing intangible or tangible assets. Understanding how to analyze your company's finances with amortization and depreciation is useful for valuable investments and revenue.