Do you know the difference between depreciation and amortization?
Two of the most misunderstood terms in the world of finance and accounting are depreciation and amortization. Both refer to the process of estimating the potential value of an asset over the length of its life, there are differences in their meanings and purpose. A monetary value is attached to all items, whether they are tangible or intangible. Some examples of tangible assets are vehicles, buildings, machinery – anything that you can see and touch. It is harder to assign value to an intangible asset because it does not have a physical form and have different lengths of life.
The value of physical assets decreases over time as you use the item and it becomes worn. A new car, for example, depreciates in value as soon as you take it off the lot. This is because you are the owner and in order to sell it now, it will have to be sold as previously owned. Plants and equipment also lose their value over time as wear and tear take their toll and repairs have to be made. Newer models coming on the market also adds to the depreciation.
Depreciation is the process used to calculate the amount of the reduced value. It is also the amount by which the value has been reduced. Even if you do not use a vehicle and leave it in the garage it will depreciate in value every year. Any item that you have listed as an asset will become less valuable in monetary terms the longer you use it. An exception is antiques because these increase in value as they age.
The process of amortization is the same as that of depreciation but it has to do with intangible assets. These do have a fixed life span and the value does decrease over time. Examples of intangible assets are copyrights and patents. Usually a patent has a life of 20 years so the cost of the patent is divided by 20 and this is the amount by which it will amortize every year so that in the last year all the value will be used.
How depreciation and amortization are different
Both depreciation and amortization are listed as debits in a company’s accounts. Although this is not money that actually has to be paid out on an annual basis, it is the amount by which the company’s assets decrease in value every year. Both of them are liabilities for the company in that they decrease the earnings, but at the same time they help build the cash flow.
You do have to calculate depreciation every year because it is a percentage. If you purchase a vehicle, there is a depreciation percentage every year that you must calculate by multiplying the current value of the vehicle by the rate of depreciation. However, there is only one calculation for amortization. You divide the life of the asset by the amount that you paid for it and the quotient is the annual depreciation.
Depreciation is used for tangible assets and amortization is used for intangible assets.