Amortisation vs Depreciation: What’s the Difference?
Ryan Thaxton November 1, 2021 1:11 PM
Amortisation and depreciation are both ways to expense assets over time and are key tools in determining a company’s value. Although which one you use differs depending on the asset type. Keep reading to learn more.
What’s the difference between amortisation and depreciation?
Amortisation is used to spread out the costs of nonphysical assets such as intellectual property and patents over their lifetime while depreciation is used to expense physical assets such as office space and equipment. Both methods are used to expense assets over a long period of time – typically longer than a year – and allow businesses to pay less interest than if they paid the entire cost of an asset upfront. Amortisation and depreciation also track the rising and falling values of company assets and calculate those assets into the rest of the company’s finances.
What is amortisation?
Amortisation is a method employed by businesses to log the decline in an asset’s value over its expected lifetime. Essentially, amortisation is logged as the devaluation of an intangible asset over its lifetime. Intangible assets subject to amortization include trademarks, licenses, franchises, goodwill and internal software. Amortisation occurs in a straight line, meaning the cost of an asset is paid at a steady rate over a predetermined period.
Intangible assets can be difficult to value, making it hard to determine their amortisation rate. Here’s an example of amortization:
- A company creates software to only be used internally and never sold for profit
- The time spent creating the software took $10,000 in hourly wages for company engineers, setting the initial value of the software at $10,000
- The company figures the software will be useful for five years before it is obsolete, so the yearly amortisation of the asset is set at $2,000
- Every year the company list a loss of $2,000 under their net asset value attributed to the amortisation of the software
- After five years the asset is completely devalued. The company can either choose to keep using the software and set a new amortisation rate or they can wipe the asset from their income statement and replace the software with something new, starting the process of amortisation over
Of course, the amortisation of intangible assets doesn’t involve actual payments by the company, but a loss is listed on their income statements for the asset because it lost monetary value.
Not all intangible assets are subject to amortization. Intangible assets such as brand recognition and goodwill do not have a predetermined shelf life. Companies can instead log changes in these assets’ values through impairment tests, a process that revaluates the asset every accounting period. The asset continues to be logged on a company’s income statement until the impairment test reveals that its cost exceeds revenue potential.
Note: Amortization may also refer to loan repayment schedules issued by financial institutions and other lenders involving a principal and interest payments. The reduction of a loan through instalments is also referred to as an amortisation schedule but should not be confused with accounting amortisation.
What is depreciation?
Depreciation is a method of expensing a physical asset over its useful life. Examples of assets that depreciate include real estate, equipment and hardware.
Note: Real estate can also appreciate, but this usually occurs because the depreciation of the physical structure lowers tax rates for the fixed cost of the land is sits on. Land is the one physical asset that never depreciates.
The timeframe over which a physical asset will depreciate, known as its useful life, can be difficult to estimate. Businesses will determine a rough estimate of both the asset’s useful life and its yearly decline when logging depreciation, but these estimations change each accounting period.
Depreciation is fixed on a company income statement one of two ways. The first is the straight-line method that is also used with amortisation. The second is an accelerated depreciation method where assets depreciate more in the early years of their life.
Accelerated depreciation can be seen in the example of buying a new car: The difference in value between a new vehicle and a vehicle used for one year is wider than a vehicle used for six years and one used for seven.
In addition to maintaining accurate valuations of assets, depreciation is a useful tool for companies to decrease taxes on asset payments. By paying off an asset’s cost during its entire useful life, the percentage paid in taxes each year decreases as the asset’s value decreases. This lowers the total sum of taxes paid on the asset than if the asset was paid for in full at the beginning of its life.
Difference between amortisation and depreciation
The difference between amortisation and depreciation is primarily the type of assets they are applied to: amortisation to nonphysical assets and depreciation to physical assets.
Another way to differentiate the two is to look at their purpose. Amortisation tracks the declining value an intangible asset adds to the company, while depreciation—also used to track asset value—results in tangible payments being made on physical assets.
Amortisation occurs in a straight-line, while depreciation can occur in both a straight-line or an accelerated method.
What is the purpose of amortisation and depreciation?
The two main purposes of amortisation and depreciation are to help a company accurately measure the value of their assets over time and to reduce tax liability by subtracting the value of their assets from net income.
How do amortisation and depreciation impact profits?
The expenses incurred through both amortisation and depreciation have no affect on a company’s gross profit, but they do decrease net income and thus lower a company’s taxable income.
Why are depreciation and amortisation added back to net income?
Amortisation and depreciation are added back to net income because they both qualify as business expenses. Business expenses are excluded from gross profit because they typically do not affect the cost of goods sold or tie directly to production.
Amortisation and depreciation are included in operating income, calculated after a company realizes their gross income, and used to determine net income, which includes all costs and revenue incurred by the business in the given period.
Amortisation vs depreciation vs capitalisation
Capitalisation is a third term you might come across when reading about amortisation and depreciation. It has many meanings, but in accounting it refers to adding an asset onto a balance sheet in order to record its cost and begin the process of amortisation or depreciation.
Put another way, amortisation and depreciation involve adjusting a company’s income statement in accordance with the — typically declining — value of different assets. Capitalisation is simply the process of initially recording the cost or expense of those assets on the balance sheet.
A company usually capitalises an asset they expect to have a long useable life. If a company expects to use an asset quickly, they will likely expense the asset in full on their balance sheet instead of capitalising it.
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