Difference between Depreciation and Amortization

Items having monetary value are classified as assets. Assets can have a physical form, or they may be intangible. Land, cash and receivables, inventory, patents, trademark, and goodwill are examples of assets. Since account receivables, marketable securities and inventories can be converted to cash in less than a year's time, they are called current assets.

Fixed assets, on the other hand, refer to property, and plant and equipment used in the normal course of business. These are not sold off for cash, since they aid the process of production. Patents, trademark, and goodwill are also considered as assets, since they add to the worth of other assets.

A brand name, like HP is automatically associated with high-quality products in the world of computers. Typically, a successful takeover results in the parent company retaining the target's brand name provided it enjoys a strong recall. Thus, trademarks, goodwill, and patents are classified as assets even though they have no physical form.

A trademark or a brand name has unlimited life, since it stays with the company as long as it is in operation. Patents, copyright, and goodwill have limited life. For instance, normal patent lifetime is taken to be 20 years from the time of filing.

Fixed assets are subject to wear and tear that result in companies having to replace the same, once they reach the end of their useful life. Assets may also become obsolete because of changes in technology, and consequently lose their value.

The value of the asset is reduced by an amount called depreciation to account for the diminishing worth of the asset over time. Depreciation is a non-cash accounting expense, since there is no actual cash outflow as a result of subtracting it from the book value of the asset.

Amortization refers to spreading the cost of a limited-life intangible asset over its lifetime. For instance, the cost of creating the patented product is spread out over its useful life, say 20 years.

The purpose of recording amortization is to measure the consumption value of intangible assets. The cost that is associated with acquiring the copyright for a particular line of product, which is expected to sell for the next 17 years or so, can be written-off over time, or amortized over time.

You now understand that the value of the patent will amortize over a stipulated period, continuing until the patent does not reach a valid expiration. A method many organizations resort to, the cost they incur courtesy of the research and development required to launch a product in the market is amortized during the lifespan of the product.

What happens is, the company that has initiated the product, through this method displays a balanced net income in the year, when the product was mentally conceived and the year, which saw the product designed and ready to be drafted into the market.

A concept that must be introduced here, called the matching principle. This concept states that the expenses ought to match the total revenue that was yielded, courtesy of the expenses incurred. If the net income suffers immense fluctuations, the investors would garner a lofty impression about the company being dicey on the question of stability.

Depreciation can be calculated using the Straight-Line method, or the Accelerated Depreciation method. For prorating the cost of a tangible asset using the straight line method, one needs to use the following formula:

Yearly Depreciation using Straight-Line Method = (Purchase Price of Asset - Approximate Salvage Value) / Estimated Useful Life of Asset

Accelerated depreciation methods, include Double Declining Balance and Sum of the Years' Digits method. This method results in greater depreciation, in the initial years, and less in the years to come, as compared to the Straight-Line method.

This in turn also reduces the taxable net income by a greater amount in the initial years. Since depreciation is a non-cash operating expense, it must be added back to net income while estimating the operating cash flow.

When it comes to calculating amortization, one divides the cost of developing or procuring the intangible asset by its estimated useful life.

For example, if the cost of a patent is $45 million and it will expire in 15 years, yearly amortization is $3 million. This is also a non-cash operating expense, so it needs to be added back to the net income for estimating operating cash flow. Amortization is deducted from gross profit for arriving at the taxable net income.

Depreciation is calculated for tangible assets while amortization is calculated for intangible assets. Depreciation may also refer to the reduction in the value of a currency as a consequence of inflation or falling interest rates. Amortization may refer to making both principal and interest payments for the purpose of discharging a debt, or mortgage loan.

Hopefully, the information would have clarified the difference between depreciation and amortization. While both result in reducing the net income, they are different on account of the nature of the assets on which they are estimated.