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Depreciation and amortization are methods for deducting the cost of business assets over several years, rather than writing off the entire cost the year you make the purchase. The concept behind both methods is to match the expense of acquiring an asset with the revenue it generates.
The key difference between depreciation and amortization is the type of asset that’s being expensed. Depreciation is used for tangible (physical) assets, while amortization is used for intangible (non-physical) assets.
Read on to learn about depreciation vs. amortization, how these two accounting methods are similar and different, and when to use one or the other.
Key Points
• Depreciation and amortization deduct the cost of an asset over its useful life.
• Depreciation applies to tangible assets (e.g., buildings, machinery), while amortization is for intangible assets (e.g., patents, trademarks).
• Both depreciation and amortization provide tax benefits by allowing businesses to deduct asset costs over time.
• Depreciation often uses straight-line or accelerated methods; amortization typically follows a straight-line schedule.
• Depreciation reflects wear and tear on physical assets, whereas amortization accounts for non-physical assets’ decline in value.
Amortization vs Depreciation
| Amortization | Depreciation | |
|---|---|---|
| Type of asset being deducted | Intangible | Tangible |
| Non-cash expense? | Yes | Yes |
| Allow for salvage value? | No | Yes |
| Accounting methods | Straight-line only | Straight-line or accelerated |
Similarities
Both depreciation and amortization are accounting methods used to spread the cost of an asset over a specified period of time. Both methods enable you to deduct a certain portion of the asset’s cost — and reduce your tax burden — annually for each year that asset is of value to your business.
In addition, both depreciation and amortization are non-cash expenses, which means they are reported on the company’s income statement, but no cash is spent.
Differences
The key difference in amortization versus depreciation is that amortization is used for intangible property (that is, property you can’t pick up and hold), such as a patent or a computer software program.
Depreciation, on the other hand, is used for fixed or tangible assets (meaning property that’s physical in nature), such as computer hardware, manufacturing equipment, and cars.
Another distinction: With depreciation, you cannot deduct the full cost of the asset. You must account for the asset’s resale value (also called salvage value) at the end of its useful life. For example, imagine you pay $20,000 for a piece of farming equipment with a useful life of 10 years, and you expect that in 10 years, you’ll be able to sell it for $5,000. In that case, you would deduct $15,000 (your net cost for the equipment) over the course of 10 years.
In addition, amortization is almost always implemented using the straight-line method, whereas depreciation can be implemented using either the straight-line or an accelerated method. The depreciation method you choose can have an effect when valuing your business, as different approaches may recognize assets’ decline in value at varying rates.
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What Is Amortization and How Does It Work?
Amortization is a method of spreading the cost of an intangible asset over a specific period of time, typically the course of its useful life. Intangible assets are non-physical in nature, but are nonetheless considered valuable assets to a business.
Intangible assets owned by a business may include:
• Patents
• Trademarks
• Copyrights
• Software
• Franchise purchase agreements
• Licenses
• Organizational costs
• Costs of issuing bonds to raise capital
Amortization is typically expensed on a straight-line model. To do so, you would divide the total cost of the asset by the number of years it will be of use to the business; the result of that equation is the amount you’d deduct each year.
To determine an intangible asset’s useful life, you need to consider the length of time that the asset is expected to produce benefits for the business. An intangible asset’s useful life can also be the length of the contract that allows for the use of the asset.
(Something to note: The term “amortization” is also used in a different way in relation to loans, such as the amortization of a car loan or mortgage. The loan amortization process involves making fixed payments each pay period with varying interest, depending on the balance.)
Amortization Example
How amortization works is relatively simple. Let’s say you purchase a license for $10,000 and the license will expire in 10 years. Since the license is an intangible asset, it would have no salvage value, so the full cost would be amortized over that 10-year period.
Using the straight-line method of amortization, your annual amortization expense for the license will be $1,000 ($10,000 divided by 10 years), meaning the asset’s value will decline by $1,000 every year. As a result, you would be able to deduct that $1,000 each year on your taxes.
What Is Depreciation and How Does It Work?
Depreciation is another method of spreading the cost of a tangible or fixed asset over a specific period of time, typically the asset’s useful life. Tangible business assets (which the IRS refers to as “property”) are high-cost physical items that are owned by a business and are expected to last more than a year. They may be items you’ve financed through a small business loan. They include:
• Buildings
• Equipment
• Computers
• Office furniture
• Vehicles
• Machinery
Unlike intangible assets, tangible assets typically still have some value even after they are no longer of use to a business. As noted above, this is the resale or salvage value. Because the IRS assumes you will sell the asset at some point, this amount must be accounted for in the beginning.
So how do you know the useful life of a tangible asset? There’s guidance in IRS Publication 946, which lists useful life by asset type. For office furniture, for example, it’s seven years. For computers, it’s five years. This time frame is also called the recovery period.
To calculate depreciation, you first need to figure out the depreciable amount, also known as its depreciable basis. You’d do this by subtracting the asset’s estimated salvage value from its original price.
The straight-line method divides the depreciable basis by the number of years in the recovery period. The result is the amount your business can deduct each year. (In this way, there’s little difference in depreciation vs. amortization.)
There are other methods of depreciation that accelerate the process, meaning that a larger portion of the asset’s value is expensed in the early years of the asset’s life. (We’ll go into more detail on those below.)
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Depreciation Example
Straight-line depreciation works in a very similar way to amortization, except that you must account for salvage value. Let’s say you purchase a $3,000 computer for your company. Per the IRS, a computer has a useful life of 60 months (or five years). You determine that after five years, you’ll likely be able to sell it for $500.
Here are the calculations you would make:
$3,000 – $500 = $2,500
$2,500 / 5 = $500
Result: Each year for five years, you would be able to deduct $500 from your taxable income.
Keep in mind that after the computer’s recovery period ends, you can (but are not obligated to) sell that computer. Either way, you would stop deducting the item’s depreciation as a business expense.
Common Methods of Depreciation and Amortization
As mentioned above, a business can amortize the full cost of an intangible asset at the same rate each year throughout the asset’s useful life. For tangible assets, the business can deduct the asset’s depreciable basis (the cost of acquiring it, minus salvage value) at a steady pace over a set number of years (the recovery period) — or it can opt to deduct variable amounts each year using other accounting methods.
The depreciation method you choose will affect how much your business is allowed to deduct as a business expense in a given year. Here’s a quick overview.
Straight-Line Method
The amortization example above is an example of the straight-line method. This method calculates the annual deduction amount through simple division: For a 10-year software license, paid upfront, you’d deduct one-tenth of the license cost each year.
You can also use the straight-line method to depreciate tangible assets. You start by calculating the depreciable basis (acquisition cost minus salvage value). Then you divide the depreciable basis by the number of years in the IRS’s designated recovery period. The result, in dollars, is each year’s depreciation expense deduction.
Units of Production Method
This method works for depreciating certain kinds of property, such as equipment. It’s based on an estimate of how many product units the property can generate during its useful life, and a measure of how many it produces in a given year. To calculate the depreciation rate, you’d divide the estimated lifetime units by the number of units actually produced during the year.
For example, if a machine is expected to produce 1,000 units during its useful life, and it produces 100 units in the first year, this represents 10% (that is, 100/1,000) of its total expected output. So the expense deduction for that year is 10% of the machine’s depreciable basis.
Declining Balance Method
This method enables business owners to front-load the depreciation deduction for some types of tangible assets. Accelerated depreciation allows you to claim larger tax deductions in the early years of the recovery period and smaller deductions later. Put another way, this lowers your taxable income more in the earlier years than it does later on.
The declining balance method involves several steps.
• Step 1: You use the straight-line method to calculate the asset’s depreciation rate.
• Step 2: You multiply that rate by an IRS-specified factor of 2; for that reason, this method is sometimes called the “double declining balance method.” (IRS Publication 946 lays out the rules and options.)
• Step 3: You apply that doubled rate to the asset’s “book value” (basis) to calculate the depreciation amount. This is the amount you deduct on your company’s tax return as a business expense.
Depreciation amount = (Straight-line depreciation rate × 2) × Asset’s book value at beginning of year
• Step 4: You then subtract last year’s depreciation amount from last year’s book value. What’s left is the new book value, which you’ll use in the upcoming tax year.
• Step 5: You repeat this process for each year of the recovery period. At the end of the recovery period, you’ll have a book value that’s roughly equal to the salvage value.
Sum-of-the-Years-Digits (SYD) Method
Another way to speed up depreciation on an asset is to use the sum-of-the-years-digits (SYD) method. This method uses a fraction to calculate the asset’s rate of depreciation for each year.
Start with the denominator. The method is to number each year in the asset’s useful life and then add them all together. For instance, a five-year depreciation schedule would result in a denominator of 15 (1 + 2 + 3 + 4 + 5).
The year numbers, in reverse order, serve as numerators. So for the first year, you’d divide 5 by 15 and get a depreciation rate of 33.33% (5/15). You’d apply that rate to the asset’s depreciable basis to get the dollar amount of your depreciation deduction.
So if your basis was, say, $1,200, your first year’s depreciation amount would be $400. The second year’s rate would be 4/15 or 26.7% of the full depreciable basis, which comes out to about $320. In year three, the rate would be 3/15 or 20%, which is $240. The percentages (and thus the depreciation amounts) get smaller over the life of the asset, until just the salvage value remains.
The Takeaway
Depreciation and amortization are both methods of calculating the value of business assets over time. Whether you use amortization versus depreciation just depends on the type of asset you’ve acquired for your business.
Amortization is used for intangible (non-physical) assets, while depreciation is used for tangible (physical) assets. As a business owner, you will want to calculate these expense amounts in order to claim them as a tax deduction and reduce your business’s tax liability.
If you’re in the market to purchase an asset (tangible or intangible) for your company but don’t want to deplete your cash reserves, you may want to explore funding options, such as a small business loan, equipment financing, or inventory financing.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
Do buildings depreciate or amortize?
Buildings are fixed assets, so they depreciate. Depreciation is used for physical assets like buildings to account for their wear and tear over time.
Can an asset amortize and depreciate at the same time?
No, an asset cannot amortize and depreciate at the same time. Amortization is used to spread out the cost of an intangible asset over time, while depreciation is used to spread out the cost of a tangible asset over time. An asset is either tangible or intangible — it can’t be both.
Is rent considered amortization?
No, paying rent is an operating expense for your business. If you own a rental property, however, you can use depreciation to spread the cost of buying or improving the property across the useful life of the property.
What types of assets are typically amortized?
Intangible assets such as patents, trademarks, copyrights, software, franchise agreements, and licenses are typically amortized. These assets are not physical, but they represent business costs and provide value to the company.
How does amortization affect a company’s financial statements?
Amortization affects a company’s financial statements by spreading the cost of intangible assets over their useful life. This means a portion of the asset’s cost can be deducted each year from the business’s taxable income, lowering the tax bill. As a non-cash expense, amortization is reported on the income statement even though it doesn’t involve an immediate cash outlay.
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