Key Differences of Amortization vs Depreciation: Expenses and Value Calculation

The concepts of amortization and capitalization address the treatment of expenditures related to assets over time. Amortisation is an accounting term used to describe the act of spreading the cost of a loan or the cost of an intangible asset over a specified period of time with incremental monthly payments. This accounting function is to help companies cover their operating costs over time, while still being able to utilise and make money from what they are paying off.

Financial planning and budgeting

In previous years, this amount would have been amortized over time, but it must now be evaluated annually and written down if, as in the case of AOL, the value is no longer there. A rule of thumb on this is to amortize an asset over time if the benefits from it will be realized over a period of several years or longer. With a short expected duration, such as days or months, it is probably best and most efficient to expense the cost through the income statement and not count the item as an asset at all. Since amortization of assets is recorded as an expense, it affects the profitability shown in the income statement.

Use of Contra Account

Amortizing an intangible asset is performed by directly crediting (reducing) that specific asset account. Alternatively, depreciation is recorded by crediting an account called accumulated depreciation, a contra asset account. The historical cost of fixed assets remains on a company’s books; however, the company also reports this contra asset amount as a net reduced book value amount.

What is the maximum amortization period for intangible assets?

• This account reduces an asset’s balance sheet carrying value by representing the percentage of its cost expensed over time.
• While the payment amounts are fixed, most amortized loans allow for prepayments or early repayment without penalties.
• The change significantly boosted economic growth and made the economy nearly $560 billion larger than previously estimated.
• HighRadius offers a cloud-based Record to Report Module that helps accounting professionals streamline and automate the financial close process for businesses.
• A good example of how amortization can impact a company’s financials in a big way is the purchase of Time Warner in 2000 by AOL during the dot-com bubble.
• However, the information gained from such accounting might not be significant because normally intangibles do not account for as many total asset dollars as do plant assets.

It holds numerous patents and copyrights for its inventions and innovations. Instead, there is accounting guidance that determines whether it is correct to amortize or depreciate an asset. Both terminologies spread the cost of an asset over its useful life, and a company doesn’t gain any financial advantage through one as opposed to the other. This is often because intangible assets do not have a salvage, while physical goods (i.e. old cars can be sold for scrap, outdated buildings can still be occupied) may have residual value.

Amortization vs. depreciation

The assets are unique from physical fixed assets because they represent an idea, contract, or legal right instead of a physical piece of property. By definition, depreciation is only applicable to physical, tangible assets subject to having their costs allocated over their useful lives. Whether it is a company vehicle, goodwill, corporate headquarters, or a patent, that asset may provide benefit to the company over time as opposed to just in the period it is acquired. To accurately reflect the use of these assets, the cost of business assets can be expensed each year over the life of the asset.

What Does Amortization Mean for Intangible Assets?

A loan is amortized by determining the monthly payment due over the term of the loan. A more specialized case of amortization takes place when a bond that is purchased at a premium is amortized down to its par value as the bond reaches maturity. The concept is again referring to adjusting value overtime on a company’s balance sheet, with the amortization amount reflected in the income statement. For individuals and businesses, understanding the amortization of loans helps in planning monthly budgets and long-term financial strategies.

Accounts Payable Essentials: From Invoice Processing to Payment

This leads to a more accurate representation of a company’s financial health and performance. In accounting, the treatment of amortization expense is a critical aspect of accurately representing a company’s financial position and performance. Amortization expense, which pertains to the systematic allocation of the cost of intangible assets, impacts both the income statement and the balance sheet. Amortization is a technique of gradually reducing an account balance over time. When amortizing loans, a gradually escalating portion of the monthly debt payment is applied to the principal. When amortizing intangible assets, amortization is similar to depreciation, where a fixed percentage of an asset’s book value is reduced each month.

Depreciation is recorded to reflect that an asset is no longer worth the previous carrying cost reflected on the financial statements. For tax purposes, amortization can provide a tax benefit as it reduces taxable income. The deductibility of amortization depends on tax laws and regulations, which may vary depending on the type amortization refers to the allocation of the cost of assets to expense of intangible asset and jurisdiction. Amortization expense is recognized periodically, typically on an annual basis. It appears as an expense on the income statement, which reduces the company’s net income for the period. The schedule also helps in understanding the total interest that will be paid over the life of the loan.

• The total payment stays the same each month, while the portion going to principal increases and the portion going to interest decreases.
• A more specialized case of amortization takes place when a bond that is purchased at a premium is amortized down to its par value as the bond reaches maturity.
• Amortization spreads out a loan’s repayment throughout its life, decreasing the outstanding debt by utilizing a portion of each payment to settle interest payments and reduce the principal.
• Amortization and depreciation are the two main methods of calculating the value of these assets, with the key difference between the two methods involving the type of asset being expensed.
• To systematically allocate the cost of an intangible asset over its useful life.

Governed by accounting standards that dictate which costs can be capitalized and how they should be treated subsequently. On a final note, despite these connections, the impact of amortization on sustainability reporting and CSR is often indirect and represents one small piece of a larger sustainability strategy. Nonetheless, the role it plays in providing an accurate representation of long-term financial health should not be overlooked.

Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. QuickBooks is here to help you and your small business grow – check out our blog to learn even more about how you can help your business succeed. Amortisation is neither good nor bad, but there are certain benefits and downsides to its utilisation.