Depreciation vs. amortization

Depreciation is an annual income tax deduction that enables you to gradually recoup the purchase price or other basis of a particular item of property throughout its usage. Amortization is a technique for recuperating some capital expenses over a predetermined time frame. It is comparable to the straight-line depreciation approach.

What can be depreciated?

Most categories of tangible property, including structures, machines, cars, furniture, and equipment, are eligible for depreciation (with the exception of land). Additional intangible property that can be depreciated includes software, copyrights, and patents.

The asset must fulfill each of the ensuing conditions in order to be depreciable.

• It has to be rental properties you own.
• It must be employed in your business or other activity that generates money; and
• Its useful life must be known.
• More than a year must be taken into account.

Information on these specifications is provided in the talks that follow.

What can not be depreciated?

Even if the conditions outlined in the discussions that came before are satisfied, the following property cannot be depreciated .

• Assets that are both put into use and disposed of away in the same year. Later on, it is taught how to determine when the property is put into service.
• Tools used to construct capital upgrades. The base of your improvements must include any otherwise permissible depreciation on the machinery used during construction.
• Intangibles covered by Section 197. These intangibles must be amortized.
• A few term investments.

What can be amortized?

Intangibles that should be amortized before 180 months  :

• Generosity.
• Value as a going concern.
• Employed personnel.
• Company records, operating systems, or any other database, including lists or other data about existing or potential clients.
• A method, procedure, design, pattern, know-how, format, or similar thing protected by a patent or copyright.
• An intangible related to customers.
• An intangible depending on a supplier.
• Anything that fits in with items 3 through 7.
• A government body or agency's granting of a license, permission, or other entitlement.
• A non-competition agreement signed in conjunction with purchasing an interest in a trade or business.
• Any trademark, trade name, or franchise.
• A term interest in or a contract for the use of any item on this list.

What can not be amortized ?

Section 197 intangibles are those acquired in conjunction with purchasing the franchise, such as player contracts, and are amortizable over 15 years .

• Contract for the use of or term interest in an intangible covered by section 197.
• Any right granted by a license, contract, or other arrangement allowing for the use of any section 197 intangible is included in the definition of section 197 intangible. It also includes any term interest, whether owned outright or in trust, in any section 197 intangible.

Property Not Covered by Section 197 Intangibles The assets listed below do not section 197 intangibles.

• Any stake in a company, joint venture, trust, or estate.
• Any interest under a currency futures contract, foreign exchange contract, contract for a notional principle, interest rate swap, or another financial arrangement of a similar nature.
• Any stake in real estate.
• The majority of software.
• Any of the aforementioned assets that were not acquired in conjunction with the purchase of a firm or a substantial portion of a business.
• An interest in a movie, song, DVD, book, or other comparable pieces of property.

1. Contractual or government-granted right to obtain physical goods or services.
2. A patent or copyright interest.
3. Some rights have a set length of time or value.

• A claim to one of the following interests.

1. An active lease or sublease on tangible property, to start.
2. An obligation that existed at the time the interest was purchased.

• The ability to service residential mortgages, unless such an ability is obtained in conjunction with the purchase of a trade or company or a significant portion of a trade or business.
• A portion of a gain or loss that is not recorded in a corporate structure or reorganization may result in some transaction fees borne by partners.

Differences between amortization and depreciation

Depreciation:

• Only applies to tangible assets.
• Decreases the value of an asset philosophically.
• There are several options from which a firm might pick, which could lead to rapid, irregular quantities being reported each year.
• When computing the depreciation base, salvage value may be taken into account.
• Always employs counteracts.

Amortization:

• Only pertains to intangible assets.
• Philosophically, only the straight-line technique is often used to spread the expense of an item.
• The same quantity is frequently recorded each year.
• Does not take salvage value into account when calculating amortization basis.
• Possibly not always employ opposing assets.

Examples of Depreciation vs. amortization

Depreciation

• Depreciation is the gradual reduction in the value of an asset due to wear and tear, obsolescence, or other factors. An example of depreciation is the loss in value of a car over time as it accumulates miles and age.

Amortization

• Amortization is the process of spreading out a loan payment over a period of time. An example of amortization is a loan with a 10-year repayment period, where the borrower pays a fixed amount each month. The monthly payments include both principal and interest, and the amount of principal and interest paid each month will vary as the loan is paid off over time.

Advantages of Depreciation vs. amortization

Depreciation and amortization are both accounting methods used to spread out the cost of an asset over its expected lifetime of use. While they have a similar purpose, they have distinct advantages and disadvantages. The following are some of the benefits of depreciation and amortization:

• Depreciation provides a tax deduction that can help reduce a company's taxable income, while amortization is typically not tax-deductible.
• Depreciation decreases the value of an asset as it is used, but amortization does not cause a reduction in the asset's value.
• Amortization payments are usually fixed and regular, while depreciation may fluctuate depending on the asset’s condition.
• Depreciation is based on the physical life of the asset, while amortization is based on the economic life of the asset.
• Amortization is applicable to intangible assets such as copyrights and trademarks, while depreciation is applicable to tangible assets such as buildings and machinery.

Limitations of Depreciation vs. amortization

Depreciation and amortization both provide methods of recovering the costs of certain assets over time, however, they have some limitations. The limitations of depreciation vs. amortization include:

• Depreciation only applies to property and equipment, while amortization applies to intangible assets such as intellectual property and goodwill.
• Depreciation uses the straight-line method, which means that the same amount is deducted from the asset’s value each year. Amortization can use different methods like the declining balance method, which accelerates the deductions to be taken in the early years.
• Depreciation does not take into consideration any residual value of the asset, while amortization does.
• Depreciation does not take into account the cost of financing, whereas amortization does.
• Depreciation is only claimed on taxes, while amortization can be claimed both on taxes and as a business expense.

Other approaches related to Depreciation vs. amortization

Depreciation and amortization are two accounting approaches to the recovery of capital expenses. In addition to these, the following techniques may be used:

• Sum-of-the-Years'-Digits (SYD): SYD is a depreciation method that accelerates the recognition of expenses in the earlier years of the asset’s life.
• Declining Balance: This method of depreciation involves applying a constant rate to the remaining book value of the asset.
• Units-of-Production: This depreciation method is used to allocate the expenses of an asset based on the amount of production output.
• Group Method: This method of depreciation involves combining several assets of the same type into a single group, and then depreciating them at the same rate.

In conclusion, depreciation and amortization are two of the most common methods for accounting for the expense of an asset over its useful life. Other methods, such as the declining balance, sum-of-the-years'-digits, units-of-production, and group methods, are also used to allocate the cost of an asset over its useful life.

Footnotes

Depreciation vs. amortization — recommended articles

Amortization of intangible assets — Business personal property — Disposal of fixed assets — Non-operating expense — Capital property — Depreciable cost — Exempt supply — Sundry income — Asset based approach

References

• Department of the Treasury Contents Future Developments. (2021). Internal Revenue Service.
• Department of the Treasury Contents Future . (2021). Internal Revenue Service.
• Bloom, M. (2013). 'Double Accounting for Goodwill: A Problem Redefined', Routledge

Author: Sonia María Soriano Marín