Difference between Depreciation and Amortization: A comparison
Amortization and depreciation are the two most common methods used for determining the correct value of business assets. Both of them are tax-deductible expenses and reduce the tax liability for an enterprise. Legally also, in the case of joint-stock companies, it is mandatory to provide for depreciation on fixed assets before declaring dividends.
In this blog, we highlight the differences between depreciation and amortization. But before jumping to that, let’s first see what each of them means, when and how they are used, and also if there are any similarities between the two.
What is depreciation?
Every business acquires different kinds of fixed assets depending upon its need and financial conditions. Such assets have a long life and whenever they are used in the business, their value gets reduced sooner or later. There is always a gradual reduction in the value of physical assets like buildings and machinery because of wear and tear. That’s why it is pertinent to charge a certain amount against revenue and deduct it from the cost of an asset so that its correct working value to the business can be ascertained.
People often get confused about the real nature and implications of providing depreciation. It is worthy of note that a provision for depreciation does not act as a safeguard against the actual diminution in an asset’s value. Whether or not you provide for such depreciation, you cannot stop the physical deterioration of an asset either due to use or on account of the passage of time.
The real purpose of providing for depreciation is to set aside a part of revenue each year to allow it to accumulate so that an adequate arrangement can be made for the replacement of the asset on the expiry of its estimated useful life. You can either merge such amount with the working capital of the business or invest it outside so as to get a requisite fund of money at the time of replacement. Such a fund should remain unaffected by any ups and downs in the financial condition of the business. This will help you prevent the payment of the replacement price of the asset out of your liquid resources.
What is amortization?
Intangible assets like goodwill, preliminary expenses, etc. are also written off against net profits in the form of amortization expenses. It represents the depreciable amount of an intangible asset that must be allocated over its useful life on a systematic basis and based on the best estimate. The future economic benefits derived from an intangible asset are consumed over time in the production of goods and services and hence, the idea is to reduce the carrying amount of the asset each year so as to reflect that consumption. This is done through a systematic allocation of the cost of the asset over its useful life as an expense.
Whether or not there is an increase in the fair value or recoverable value of an asset, amortization is recognized. The objective of amortizing an asset is to match the expense of acquiring it with the revenue generated from it.
Amortization commences from the year an asset is available for use. It is often a rebuttable assumption that an intangible asset has a useful life of a maximum of ten years from the date such asset is available for use.
Journal entry of depreciation and amortization
Without provision:
For charging depreciation directly to the asset:
Depreciation Account – Debit
To Asset Account – Credit
The asset in this case will appear at its reduced value in the balance sheet, i.e., Cost/Book value minus depreciation for the accounting year.
For transferring expense to profit and loss statement:
Profit and Loss Account – Debit
To Depreciation Account – Credit
With provision:
For charging depreciation:
Depreciation Account – Debit
To Provision for Depreciation Account – Credit
The asset account in this case does not get affected by the amount of depreciation and appears in the ledger and the balance sheet at its original cost.
The amount of depreciation written off is accumulated in the Provision for Depreciation account.
In the balance sheet, the asset account is shown at its original cost minus the balance in the provision for depreciation account. Alternatively, the balance in the provision for depreciation account may also be shown on the liabilities side of the balance sheet.
For transferring expense to profit and loss statement:
Profit and Loss Account – Debit
To Depreciation Account – Credit
For transferring the amount of total accumulated depreciation to the asset account in case the asset is sold or discarded:
Provision for Depreciation A/c – Debit
To Relevant Asset A/c – Credit
Note: The journal entries for recording amortization are the same as those for depreciation. The only difference is that Amortization Account & Accumulated Amortization Account is used in place of Depreciation Account & Provision for Depreciation Account respectively.
Similarities between depreciation and amortization
Depreciation and amortization also share some common aspects, which are outlined as below:
Non-cash expense:
Both depreciation and amortization are non-cash expenses. They reduce the net profits of a business without affecting the cash balance.
Since depreciation is a non-cash expense, the amount so charged against the profit and loss account every year is retained in the business so as to make funds available at the time of replacement of the assets.
Neither depreciation nor amortization results in an outflow of cash and hence, if you want to find out the real cash generated from your business operations, you will have to add back the amount of depreciation or amortization charged to net profit.
Charge against profit:
Both depreciation and amortization are a charge against revenue earned or profit derived for a particular accounting year.
Not affected by market value:
Depreciation and amortization (both of them) are not affected by market value. Even though the market price of an asset fluctuates, it has no bearing on the amount of depreciation/amortization provided on the asset.
Cannot exceed original cost:
The total amount of depreciation/amortization can never be more than the depreciable value of an asset or its original cost where the scrap value is nil.
Help in ascertaining correct profit and true financial position:
Since assets are used by entities to generate income for the business, any loss in their value must be deducted from the income in order to compute the real profit of the business. Moreover, all assets must be shown in the books at their true values after deducting a reasonable amount of depreciation/amortization. This enables entities to show their true financial position on the balance sheet. If no depreciation/amortization is provided, the assets will stand at overstated figures in the balance sheet which will be against sound business principles.
Another objective of providing depreciation is to ascertain the proper cost of the products manufactured in a business. It is necessary to charge depreciation as an item of cost of production in order to determine the fair cost of production.
Depreciable fixed and intangible assets:
For charging both depreciation and amortization, it is imperative to judge if fixed and intangible assets are depreciable. Depreciable fixed and intangible assets are those that are expected to be used during more than one accounting year, have a definite useful life, and are held for use in the production of goods and services but not for sale in the ordinary course of business. If any of these conditions is not satisfied, then the asset is not depreciable. For instance, “land” is not a depreciable asset since it does not have a limited useful life.
Differences between depreciation and amortization
The following are the major differences between depreciation and amortization:
Nature of asset:
The most common difference between depreciation and amortization is the type of asset being expensed.
Depreciation is computed only in respect of fixed physical assets, for example, plant, building, machinery, furniture, etc. On the other hand, amortization refers to the practice of writing off the cost of intangible assets such as copyrights, patents, trademarks, goodwill, franchise agreements, and so on.
Methods used
Several methods are available to entities for providing depreciation. A few names are Fixed Instalment Method or Straight-Line Method, Depreciation Fund (Sinking Fund) Method, Insurance Policy Method, Annuity Method, Diminishing Balance Method (Reducing Balance Method), Sum of Years’ Digits Method, Depletion Method, Machine Hour Rate Method (Service Hours Method), etc.
Unlike depreciation, amortization is typically provided using Straight-Line Method. The amortization method that an enterprise chooses must be such that it is commensurate with the pattern in which the asset’s future economic benefits are consumed over time. If no such pattern can be reliably determined, then the straight-line method must be used. In the straight-line method, the same amount of amortization is charged as an expense in every accounting period.
Salvage value
It is very much possible that tangible assets may have a residual scrap value or resale value when their expected useful life gets expired. Such scrap value is deducted from the asset’s original cost to determine the depreciable amount of an asset, which then gets written off on a proportionate basis every year.
Suppose an entity acquires a piece of machinery for $500,000 and sells it for $100,000 after using it in business for 5 years. The cost of the machinery utilized in the business is $400,000 ($500,000 – $100,000). This cost (depreciable value) needs to be allocated as an expense of the business at the rate of $80,000 ($400,000 ÷ 5) for each of the 5 years in which the machinery has been used to generate income. This $80,000 represents the amount of deprecation per year.
Conversely, amortization deals with the expensing of the acquisition cost of intangible assets over their estimated useful life in a systematic manner. These intangible assets can be franchises, patents, trademarks, or copyrights and they do not usually have a salvage value.
Concerned accounting standard
Indian Accounting Standard (Ind AS) 16 “Property, Plant and Equipment” covers the principal issues concerning the timing of recognizing an asset, determination of carrying amounts of the assets, and depreciation.
On the other side, Indian Accounting Standard (Ind AS) 38 deals with intangible assets and their amortization. As per Ind AS 38, an asset’s amortization charge for every accounting period must be recognized as an expense in the profit and loss statement unless some accounting standard requires it to be disclosed as part of the carrying amount of another asset.
Takeaway
Depreciation is a gradual and continuous reduction in the book value of a fixed asset. It takes place irrespective of any regular repairs or maintenance. As an asset is used for business purposes, the annual loss in its value is just like any other expenditure to the business. Therefore, its cost has to be written off as a loss over its useful life.
On the flip side, amortization is a technique of lowering the book value of an intangible asset (and not a physical asset) over a specific period of time regularly. Its objective is to match the cost of the asset to the revenues generated by the asset in accordance with the matching principle.
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