Amortization vs depreciation (examples)

What is amortization?

Amortization is an allocation of an intangible finite asset’s initial cost over its service life. To calculate the amortization of finite assets entities usually use the straight line amortization method which is the same as for depreciable assets. When calculating amortization an entity should deduct capital expenses over service life of an asset.

Formula:

Amortization expense per year = (initial cost* – residual value**) / # of years of services life.

*Initial cost of an amortizable asset is the purchase price and any other cost related to it in order to get the asset ready for its intended use.

**Residual value is remaining estimated worth of the amortizable asset (if any) at the end of its service life. It is the fair market value that the potential buyers might be willing to pay for it.

What is accounting entries to record an intangible asset’s amortization

Dr. Intangible asset amortization expense

Cr. Intangible asset (name)

(to record an annual amortization expense of an intangible asset)

The amortization computations are almost the same as they would be in case of depreciation, except that in computation of amortizable assets involved intangible finite assets, but depreciable assets include tangible assets. Therefore, the difference between depreciation and amortization is that amortization refers to intangible finite assets while depreciation relates to tangible depreciable assets.

What is depreciation?

Depreciation is the process of spreading the purchased depreciable asset’s initial cost over its useful life. Companies use the depreciation methods to have reasonable and consistent revenue / expense matching. Commonly used depreciation methods are straight line (the easiest and most used one) and accelerated depreciation methods such as sum of the years’ digits, declining balance (items such as 200% and 150%), and units of production. All of the depreciation methods have their own advantages and disadvantages and a firm depending on the specification of certain depreciable asset may choose for it the right accounting method which will benefit them the most.

Which depreciation method is better?

Typically entities choose the depreciation method depending on specifications of a depreciable asset and the goals they pursue, whether they want to show lower or higher reduction amounts. However, it is not all the time the case. Since all types of properties have their own unique characteristics even within the same company for different depreciable assets can be chosen different depreciation methods. This is due to the fact that some assets wear out faster than the other or require more maintenance cost with years of service. For example, if for an office table the straight line depreciation method might be appropriate, but for computers or some equipment it might be more appropriate to use one of accelerated depreciation methods (due to the rapidly changing technology). In addition, such depreciation method as units of production cannot be applies to all depreciable assets. It is not the right method for such assets as furniture and buildings which weariness depends usually on the years used rather than on the production levels. The firm can change the selected accounting method of depreciable assets later on if necessary, but they should reflect that in the notes to the financial statements for the period.

What accounting entries to record depreciation?

Dr. Depreciation expense

Cr. Accumulated depreciation