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Comparing Amortization and Depreciation

Comparing Amortization and Depreciation
Lauren Ward

Lauren Ward

Updated March 28, 2022
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Depreciation and amortization can be confusing concepts, but it’s important to understand what these terms mean and how they differ in order to minimize your business’s tax liability each year.Both depreciation and amortization are methods for deducting the cost of business assets over a number of years, rather than writing off the entire cost the year you make the purchase. The concept behind both is to match the expense of acquiring an asset with the revenue it generates.The key difference between depreciation and amortization is the type of asset being expensed: Depreciation is used for tangible (physical) assets, while amortization is used for intangible (non-physical) assets.Read on to learn exactly how depreciation and amortization work, how these two accounting methods are similar and different, and when to choose one or the other. 

What is Amortization and How Does It Work?

Amortization is a method of spreading the cost of an intangible asset over a specific period of time, typically the course of its useful life. Intangible assets are non-physical in nature, but are nonetheless considered valuable assets to a business.Types of intangible assets a business may have include:
  • Patents
  • Trademarks
  • Copyrights
  • Software
  • Franchise agreement
  • Licenses
  • Organizational costs
  • Costs of issuing bonds to raise capital
Amortization is typically expensed on a straight-line basis, which means that you would divide the total cost of the asset by the number of years it will provide use to the business, then deduct that amount each year. How do you determine an intangible asset’s useful life? For intangible assets with an indefinite life (such as a trademark), the amortization period should be 15 years, per the IRS. If the asset has a definite life span (such as software that will become outdated or a license that expires on a certain date) then you would determine how long the asset will be useful to your business.(Something to note: The term "amortization" is also used in a different way in relation to loans, such as the amortization of a car loan or mortgage. The loan amortization process involves making fixed payments each pay period with varying interest, depending on the balance.)Recommended: Guide to Applying for and Getting Small Business Loans 

What Is Depreciation and How Does It Work?

Depreciation is the process of spreading the cost of a tangible or fixed asset over a specific period of time, typically the asset’s useful life. Tangible business assets (which the IRS refers to as “property”) are high-cost physical items that are owned by a business and are expected to last more than a year. They include:
  • Buildings 
  • Equipment
  • Computers
  • Office furniture
  • Vehicles
  • Machinery
Unlike intangible assets, tangible assets typically still have some value even after they are no longer of use to a business. This value is known as resale or “salvage” value. Because the IRS assumes you will sell off the asset at some point, this amount must be accounted for in the beginning. What is the useful life of a tangible asset? You can refer to IRS Publication 946 Table B-1 for guidance, which provides useful life by asset type. For office furniture, for example, it’s 10 years. For computers, it’s five years. To calculate depreciation, you need to first subtract the asset's estimated salvage value from its original cost. Using the straight-line deduction method, you would then take that number and divide it by the number of years the asset will be of use to your business. There are other methods of depreciation that accelerate the process, meaning that a larger portion of the asset's value is expensed in the early years of the asset's life.

Amortization vs Depreciation

Similarities

Both depreciation and amortization are accounting methods used to spread the cost of an asset over a specified period of time. And, with both, you are able to deduct a certain portion of the asset’s cost — and reduce your tax burden — each year for the number of years that asset is of value to your business. In addition, both depreciation and amortization are non-cash expenses, which means they are reported on the income statement of the company but no cash is spent.

Differences

The key difference between amortization and depreciation is that amortization is used for intangible property (meaning property you can’t pick up and hold), such as a patent or computer software program. Depreciation, on the other hand, is used for fixed assets or tangible property (meaning assets that are physical in nature), such as computers, manufacturing equipment, and cars. However, with depreciation, you cannot deduct the full cost of the asset. You must account for its resale value at the end of its useful life. For example, if you pay $20,000 for a piece of farming equipment and at the end of its useful life (10 years) you think you’ll be able to sell it for $5,000, then you would only deduct $15,000 over the course of ten years. Another major difference is that amortization is almost always implemented using the straight-line method, whereas depreciation can be implemented using either the straight-line or an accelerated method. 

Amortization Example

How amortization works is relatively simple. Let's say you purchase a license for $10,000 and the license will expire in 10 years. Since the license is an intangible asset, it would have no salvage value and the full cost would be amortized over that 10-year period. Using the straight-line method of amortization, your annual amortization expense for the license will be $1,000 ($10,000/10 years), meaning the asset will decline in value by $1,000 every year and you would be able to deduct $1,000 each year on your taxes.

Depreciation Example

Depreciation works in a very similar way to amortization, except that you must account for salvage value. Let’s say you purchase a $3,000 computer for your company. Per the IRS, a computer has a useful life of five years. After five years, you determine you’ll likely be able to sell it for $300. Here are the calculations you would make:$3,000 - $300 = $2,700$2,700/5 = $540That means that each year for five years, you would be able to deduct $540 on your taxes. Keep in mind that after the end of the computer’s designated useful life, you can, but are not obligated, to sell that computer. You would simply stop deducting the item’s depreciation as a business expense.

The Takeaway

Depreciation and amortization are both methods of calculating the value of business assets over time. Amortization vs depreciation just depends on the type of asset you have acquired for your business. Amortization is used for intangible (non-physical) assets, while depreciation is for tangible (physical) assets. As a business owner, you will want to calculate these expense amounts in order to use them as a tax deduction and reduce your business’s tax liability.If you’re in the market to purchase an asset (tangible or intangible) for your company but don’t want to deplete your cash reserves, you may want to look into financing, such as a small business loan, heavy equipment financing, or inventory financingIf you’re interested in finding out what type of financing your business might qualify for, Lantern by SoFi can help. With our online lending tool, you can instantly get access to small business loan options matched to your needs and qualifications with just one application.
Photo credit: iStock/dusanpetkovicThe tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. SOLC0122032

Frequently Asked Questions

Do buildings depreciate or amortize?
Can an asset amortize and depreciate at the same time?
Is rent considered amortization?

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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