Depreciation and Amortization are two terms that are commonly seen and used in accounting and finance but are often misunderstood. While both refer to the same process of estimation of an asset’s useful life, there is a difference between depreciation and amortization which this article intends to make clear.
All items, whether tangible or intangible have a monetary value and they are described as assets. Plant and machinery, car, property, gold, and cash are examples of tangible assets, while trademark, goodwill and patents are also assets despite not existing in physical form, they are intangible assets. Different assets have different lifetimes.
Depreciation
Physical assets are subject to wear and tear and their value gets reduced with passage of time. For example, if you buy a new car for $10000 and just take it from the showroom to your home, its value is deemed to have reduced by 5%. This is because it becomes second hand to someone who might be interested in buying it. In other cases, plants and machinery, equipment etc regularly lose their value over period of time as wear and tear takes place or newer models may come into the market. The value of the asset is reduced by an amount that is known as depreciation. The decreasing value of an item is accounted for using depreciation. Taking the example of your car again, if it gets depreciated by 25% every year, obviously its value after one year of use will be $7500 even if it has not been used and kept standing. So if your car has been shown as an asset in your accounts, its value in accounts will diminish over a period of time until it is reduced to nil.
Amortization
Amortization is a process that is exactly same as depreciation, the only difference being intangible assets that we cannot see or touch that get reduced in their value. Intangible assets have a fixed life span. For example, the life of a patent is taken to be 20 years and it is written off gradually over this period of time from account books. For example if a company produces a drug and gets its patent for 10 years but had to spend $10 million for it, one million dollar will be accounted each year for a period of 10 years as amortization expense in account books.
Difference between Depreciation and Amortization
Both depreciation and amortization are shown in the debit column and are a liability of the company. Being non cash expense, they act as a liability that decreases the earning of the company but help in increasing the cash flow of the company.
While depreciation requires calculation every year, amortization is pretty straight forward and you know how much amortization expense to be added to the liability column every year over the life span of the intangible asset. But the biggest difference between the two terms lies in the fact that depreciation applies to tangible assets while the word amortization is used for intangible assets.