Depreciation and Amortization - Difference between Depreciation and Amortization

Items having monetary value are classified as assets. Assets can have a physical form or they may be intangible. Plant and machinery, 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 an year's time, they are known as current assets. Fixed assets, on the other hand, refer to property, 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.

Difference between Depreciation and Amortization

Depreciation and Amortization - Definition
Depreciation: 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 depreciation from the book value of the asset.

Amortization: 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.

Calculating Depreciation and Amortization Expense
Calculating Depreciation: 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. The accelerated depreciation 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 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.

Calculating Amortization Expense: 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. Like depreciation, amortization is also deducted from gross profit for arriving at the taxable net income.

Other Meanings for Depreciation and Amortization
As mentioned earlier, 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 like car loan or mortgage loan.

Hopefully, the above article 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.