Depreciation vs. Amortization 

Understanding the differences between depreciation and amortization is essential for managing assets and financial reporting. Both are methods of allocating the cost of an asset over its useful life, but they apply to different types of assets and have distinct implications for tax and accounting purposes.

In this post, we’ll break down depreciation and amortization, explore how they work, and highlight their key differences so you can better manage your finances and make informed business decisions.

What is Depreciation?

Depreciation is the process of deducting a tangible asset’s value over its useful life. Some investors conduct this calculation by deducting an asset’s salvage value from its original purchase price. Salvage value represents the amount you could receive from an asset if you decided to resell it. Depreciation is a tax deduction, so it benefits investors to state their assets have gone through higher depreciation. However, you cannot depreciate an asset further if you have already depreciated all of its value through this accounting trick.

Depreciation Methods

Investors can use several depreciation methods to arrive at their calculations. These are the top choices to consider:

• Straight-Line Method: This method uses a fixed amount of depreciation every year through the asset’s useful life. If you depreciate $5,000 from an asset this year with the straight-line method, you will also depreciate $5,000 from the same asset next year.
• Declining Balance: Depreciation is based on a fixed percentage rather than a fixed value. That means depreciation will be higher earlier in the asset’s useful life.
• Double Declining Balance Method: The same method as the declining balance method, but an investor doubles the total depreciation each year. This strategy results in faster depreciation of the asset. You get higher initial tax breaks but burn through the asset’s useful life sooner.
• Sum-of-the-Years' Digits Method: An investor determines an asset’s useful life and calculates its sum in years. For instance, an asset with a three-year useful life has a sum of six (3 + 2 + 1 = 6). This sum becomes the denominator for each of the years. In Year 1, the depreciation rate is 3/6. In Year 2, the depreciation rate is 2/6. In Year 3, the depreciation rate is 1/6. The total adds up to 6/6, representing 100% depreciation at the end of the asset’s useful life.
• Units of Production: An investor considers how much utility they want to get out of an asset before deeming an end to its useful life. If you want to drive 200,000 miles in a vehicle, and you drive 20,000 miles this year, the depreciation rate for that year is 10%. 

What is Amortization?

Amortization is the process of gradually paying off a debt or allocating the cost of an intangible asset over a specified period of time. In accounting, it refers to spreading the expense of an intangible asset—such as patents, trademarks, or goodwill—over its useful life. This allows companies to reflect the decrease in value of intangible assets in their financial statements.

In the context of loans, amortization involves breaking down a loan into fixed, scheduled payments that cover both the interest and principal. Over time, a larger portion of each payment goes toward the principal, while the interest portion decreases. This is common in mortgages and car loans.

The purpose of amortization is to ensure that costs or debt are systematically accounted for, making it easier for businesses and individuals to manage finances over the long term.

Comparing Depreciation and Amortization

Depreciation and amortization are both similar ways to reduce an asset’s cost and capitalize on tax deductions. These are some of the key factors to know about each approach.

The Type of Asset

Depreciation applies to physical assets with tangible value. Real estate, art and machinery are some of the assets that fit this category. Amortization is specifically for intangible assets, such as a brand’s image, copyrights and trademarks.

Choices

Investors using amortization are stuck with the straight-line method. However, investors using depreciation can choose from several methods that impact short-term and long-term depreciation values. You can have an asset depreciate at a higher rate if you want higher upfront tax deductions.

Salvage Value

Depreciation calculations deduct the salvage value from the asset’s purchase price. However, intangible assets do not have salvage value, so it is not deducted from their value when conducting amortization calculations.

Speed of Decay

Amortization uses the straight-line method, which results in steady write-offs over time. However, investors have multiple ways to calculate depreciation and can intentionally speed up the depreciation of an asset. Accelerating depreciation allows investors to capitalize on higher tax deductions during the initial years of an asset.

Mentality

Amortization refers to spreading an asset’s cost over time and using write-offs. Depreciation involves diminishing an asset’s value and using it as a tax deduction. Amortization and depreciation both help investors save money.

Turn Your Assets into Tax Deductions

Depreciation and amortization help investors turn their assets into tax write-offs. Savvy investors can use these costs to increase cash flow and generate higher returns on their investments.

Frequently Asked Questions