Businesses rely on depreciation and amortization to control how much they cost them over time, whether those costs are associated with tangible or intangible assets. The depreciation applies to tangible assets – equipment and buildings with residual value, which shows wear over a period of time while distributing the cost throughout each year. Amortization: Represents the write-off of intangible assets (purchased patents, trademarks) which are amortized over their economic useful life by using the straight-line method and there is no consideration for residual value. Both have very specific places in the world of tax and finance. When utilized properly, each can be a great way to maximize your financial picture.
Depreciation: for tangible assets
Depreciation refers to the deterioration of tangible fixed assets like machinery, buildings, vehicles, and so on. Thus, it allocates the cost of an asset over a useful period reflecting on the reduction in its value due to wear and tear, aging, or technological progress. This could be illustrated, for example, where a manufacturing company acquires machinery worth $500,000 carrying an expected in-service life of, say, 10 years and a residual value of $50,000. The annual depreciation expense helps in capturing the fall in value and wear of this machinery accurately.
Most companies in the US use only a straight-line method to calculate depreciation by recording equal amounts of depreciation each year. For example, your company depreciates at $45,000 per year. This is an easy way to keep more orderly books of account. The double declining balance method and others are more appropriate for assets subject to rapid depreciation in the early years, such as technology sector high-tech equipment.
Amortization: For intangible assets
Amortization is the depreciation of intangible assets like patents, trademarks, copyrights, and software. Since these non-physical assets are missing a life of their own, amortization is naturally the process by which one should account for how slow or low it costs to lose value. In this example, a tech company purchases a patent for $1 million and the expected duration of its usefulness is 10 years. This $100,000 annual amortization expense represents the continual decrease in the value of a patent.
Given an intangible asset has a relatively stable value consumption, amortization is typically performed on the straight-line basis. Consider the case where a publicized software company carries its software licenses at costs on financial statements, amortizing these annually over their useful life means that largely equal portions of R&D cost will be in evidence.
Key Differences
Type of assets: Depreciation is of tangible assets and amortization is intangible. To give an example, a big car manufacturer will find itself write off production line equipment and office buildings out of its books while amortizing brand trademarks and technical patents.
How residual values are treated: In the context of depreciation, we would be processing that calculation with an eye toward whether or not there is a remaining value upon which to base amortization (not so when it comes to how intangibles factor in this scenario). A $200,000 production machine may have a residual value of only $20,000 at the end of its useful life (though software often has no residual value).
Legal requirements: Each country and region has its accounting standard for the amortization of intangible assets. In IFRS, goodwill does not amortize but there is an impairment test performed annually. For example, a large multinational corporation wrote off $30 million of its book value for goodwill impairment as part of its annual financial audit.
Depreciation affects the book value of tangible assets, whilst amortization impacts intangible assets. One of the world’s most valuable tech companies depreciated $250,000,000 in tangible assets and amortized down an intangible asset account by 80MM on their balance sheet in 2023.
Practical significance
Both depreciation and amortization are important ways to true-up the cost of using assets which in turn affects a company’s profitability and financial condition. For example, a US manufacturing company erodes its annual before-tax profit by roughly $250MM through the depreciation of equipment, and the book value for software investments diminishes to the amount surface in both accounts as amortization-accounting ($50 MM annually).
Depreciation and how to properly apply it allows businesses several tax benefits. A construction company, for that matter, increased their equipment depreciation, thus decreasing taxable income by $15. Amortization: Amortizing R&D and brand-building costs provides a more rational approach to cost allocation for long-lived assets. A top pharmaceutical company annually depreciates its patents to finally pass on the impact of R&D investments over 10 years.
