If you're looking to invest in a publicly-traded company, a close look at its income statement can help you assess its financial performance. There are many different terms and financial concepts in income statements.
Depreciation and amortization are two concepts that are often misunderstood, but they are both used to account for the diminishing value of assets over time. Depreciation of an intangible asset is split up over time by amortization, and depreciation occurs when a fixed asset loses value over time by depreciation.
Amortization and depreciation are capital cost recovery tax deductions for businesses. Specific rules governing the use of these deductions are regulated by the Internal Revenue Service.
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What is Amortization?
The process of spreading the cost of an intangible asset over the asset's useful life cycle is known as amortization. Intangible assets are not physical assets. Amortization is typically expensed on a straight-line basis, which means that over the asset's useful life cycle, the same amount is expensed at the same time.
Unlike depreciation, assets expensed using the amortization method usually have no resale or salvage value. The following are examples of intangible assets that are expensed through amortization:
Because the word amortization has two meanings, it's important to be aware of the context in which you're using it.
In the case of a mortgage, an amortization schedule is used to calculate a series of loan payments that include both the principal and interest in each payment. As a result, the term amortization has completely different meanings in accounting and lending.
Types of Amortization
We’ve listed some common Types of Amortization below :
Fully amortization with full rate
With a fixed-rate, full amortization is possible. A fully amortized loan is one that will be paid off in full at the end of the repayment period. Many personal loans and mortgages have fixed interest rates and payments and are fully amortized.
Full Amortization with Variable rate
Adjustable-rate mortgages are an example of fully amortized loans with a variable interest rate (ARMs). Each time the interest rate changes, the loan is re-amortized, and a new amortization schedule is created. As a result, the loan will still be paid off in 30 years, but your payments will fluctuate as the interest rate on the loan changes.
Full amortization with deferred interest
Some partially amortized loans may have interest-only payments for a period of time before switching to fully amortizing payments for the rest of the term.
For example, if a loan has a 30-year term, the client may only be required to make interest payments for the first ten years. Some HELOCs have an interest-only draw period followed by a fully amortized repayment period.
Partial amortization with a balloon payment
Some partial amortization loans have a balloon payment after the initial deferment or interest-only period. However, keep in mind that balloon payment is typically more than twice the loan's average monthly payment and can be in the thousands of dollars.
If you're thinking about taking out a loan with a balloon payment, think about whether you'll be able to pay it off when the time comes.
In the negative Amortization method, the total payment for a period is less than the interest charged for that period. It means that the periodic payment will not be enough to repay the principal, and the remaining interest charge will accumulate, increasing the outstanding balance of the loan. The loan balance accumulates over time before being repaid at the end of the term.
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What is Depreciation?
Depreciation is a method of lowering the long-term costs of a fixed asset by breaking down the expenses associated with it. Physical or tangible assets that depreciate in value over time are referred to as fixed assets. Depreciation numbers assist business owners in determining the cost of an item in relation to the revenue it generates.
Fixed assets include the following:
It is common for tangible assets to retain some value after their estimated life span has expired. This is known as the salvage or resale value of an asset, and it is deducted from the asset's original cost. Typically, companies deduct the depreciated amount over the asset's useful life.
An office building, for example, can be used for several years before becoming run down and being sold. The cost of the building is spread out over the structure's expected life, with a portion of the cost being expensed in each accounting year.
Some fixed assets can depreciate at a faster rate, which means that a larger portion of the asset's value is expensed in the first few years of its lifecycle. An example of accelerated depreciation is a vehicle.
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Types of Depreciation
Balance is deteriorating. Depreciation is a type of accelerated depreciation that shows how the value of a fixed asset depreciates as it is used.
Equation: Straight-line percentage x the remaining depreciable amount for each year
This method of depreciation is referred to as accelerated depreciation. The double-declining balance depicts how the amount of depreciation increases rapidly at the start of an asset's life cycle and gradually decreases toward the end.
Equation: 2x (original cost of an asset - the scrap value / estimated asset life)
The most common depreciation method is straight-line depreciation. It requires a company to spread out the depreciation expenses of an asset evenly over each year that the asset is expected to work and function properly.
Equation: (Original asset cost - scrap value) / estimated asset life
Units of production
Units of production depreciation is a type of depreciation in which a company adjusts the charge amount of an asset's depreciation based on how much the asset is used over time. It does not, like the straight-line method, spread out even charges over the lifecycle of an asset. Depreciation is instead treated as an active asset.
Equation: (Cost of fixed asset - residual value / estimated total production) x actual production
This is an accelerated depreciation method in which companies charge more for depreciation at the start of an asset's lifecycle and gradually reduce depreciation charges as the asset's life cycle progresses.
Equation: Deprecation base x (remaining useful life/sum of the digits of the year)
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Difference between Depreciation and Amortization
The primary distinction between Amortization and depreciation is that Amortization deducts the cost of an intangible asset, whereas depreciation deducts the cost of a tangible asset.
Another distinction between the two concepts is that Amortization is almost always carried out on a straight-line basis, which means that the same amount of Amortization is charged to expense in each reporting period.
Another distinction between amortization and depreciation is that amortization does not typically include any salvage value because an intangible asset is not typically considered to have any resale value after its useful life has expired.
A tangible asset, on the other hand, may have some salvage value, which is more likely to be factored into the depreciation calculation.
The term "depreciation" refers to the reduction in the cost of tangible fixed assets over their useful lives, which is proportional to the asset's use in that year.
Amortization is the gradual reduction in the cost of intangible assets.
There are several methods for calculating depreciation, including straight line, reducing balance, and annuity. Amortization can be calculated using a variety of methods, including Straight Line, Reducing Balance, Annuity, Bullet, and so on.
Depreciation is a method of determining the value of tangible assets such as machinery, vehicles, computers, and furniture. Intangible assets, on the other hand, are assets that exist in their non-physical form, such as royalty, copyright, computer software, import quotas, and so on.
The goal of depreciation is to spread an asset's cost out over its useful life, whereas the goal of amortization is to capitalize an asset's cost over its useful life.
Depreciation is governed by the AS-6 accounting standard. AS-26 is the governing amortization accounting standard.
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Both processes are non-cash expenses, but they must be set aside as a provision because assets have a finite life and must be replaced in a timely manner if the company is not to lose labor productivity.
That is why using these two accounting concepts is crucial and paramount. Depreciation and amortization are two terms that are frequently used interchangeably, but they are governed by different accounting standards.
A company should understand the significance of these two accounting concepts and how much money should be set aside for the future purchase of an asset. At least once a year, business assets should be tested for impairment, allowing the company to determine the asset's true market value.
The depreciation of assets also aids the business in forecasting cash requirements and determining when the likely cash outflow will occur.