What is Depreciation?
An asset’s value declining over time is referred to as depreciation in accounting. It is the process by which an asset loses its value due to wear and tear, obsolescence, or other factors.
There are several different methods of calculating depreciation, but the most used are the straight-line and accelerated methods. Under the straight-line method, the same amount of depreciation is taken each year over the asset’s life.
The asset’s useful life and the depreciation rate determine how much depreciation is taken each year. The useful life is the estimated time the asset will remain productive. The depreciation rate is the percentage of the asset’s value that can be claimed as a deduction. Depreciation is a non-cash expense and does not require any money to be spent or received.
Depreciation is an integral part of asset management and tax planning for businesses. It can reduce a company’s taxable income, allowing it to reinvest its profits into the business and grow.
What is Amortization?
Amortization spreads a loan into a series of fixed, equal payments over a set period. Instead of paying the interest and principal in full at once, amortization lowers the amount of interest paid throughout the loan. Each payment is divided into two components: the principal portion, which reduces the loan balance, and the interest portion.
The principal portion of each payment increases as the loan is paid down, while the interest portion decreases. More of the payment will go toward the primary and less toward the interest as the loan is repaid, which results in a decrease in the overall amount of interest paid throughout the loan.
Amortization is used to pay off large loans such as mortgages, car loans, and student loans, and also used to pay off credit cards, but in this case, the interest rate is higher, so there may be other cost-effective ways to pay off the debt.
In addition to reducing the amount of interest paid over the life of the loan, amortization also makes it easier to budget for payments. Since the payments are fixed, the borrower knows how much they will owe each month and can budget accordingly.
Difference Between Depreciation and Amortization
- Depreciation primarily aims to allocate a tangible asset’s cost over its useful life, while amortization’s primary purpose is to allocate an intangible asset’s cost over its useful life.
- Depreciation refers to allocating the cost of tangible assets, such as buildings, furniture, and equipment, while amortization refers to allocating the cost of intangible assets, such as patents, copyrights, and trademarks.
- Depreciation is used for tangible assets that have a physical life. On the other hand, amortization is used for intangible assets that have a contractual or legal life.
- Depreciation accounts for the decrease in the value of an asset due to wear and tear obsolescence or other factors. Amortization accounts for the decrease in the value of an asset due to the passage of time.
- Depreciation is not affected by the passage of time. Amortization is affected by the passage of time.
Comparison Between Depreciation and Amortization
| Parameters of comparison | Depreciation | Amortization |
| Allocation | used to allocate the cost of tangible assets | used to allocate the cost of intangible assets |
| Methods of calculating | can be calculated using different methods | calculated using the straight-line method |
| Recorded | as an expense in the income statement | as a deduction from the asset in the balance sheet |
| Expense | is a non-cash expense | is a cash expense |
| Calculations | calculated based on the asset’s salvage value and its useful life | calculated based on the asset’s initial cost and its useful life |