Fixed assets are resources that generate economic benefit for a business over a long duration, often across several accounting periods. Fixed assets are thus initially capitalized and subsequently a part of its cost is expensed out in each accounting period. This is also in line with the ‘matching concept’ in accounts which provides that expenses are to be charged in the books in the same accounting period in which the revenues they help generate are recorded
This article looks at meaning of and differences between the two different forms of cost allocations of fixed assets – depreciation and amortization.
Definitions and explanations
Depreciation is the reduction in value of a tangible asset on account of wear and tear that occurs during the course of its use. Depreciation is an allocation of the cost of the tangible asset across its useful life. Depreciation is charged on tangible assets such as plant and machinery, vehicles, furniture and fittings, office equipment etc.
The amount of depreciation to be charged is determined with reference to the useful life of an asset. For example, a vehicle used in the business may be expected to have a useful life of say 5 years, whereas large scale plant and machinery on the other hand may be expected to have a useful life of 10 years.
The accounting entry passed for depreciation is as follows:
Depreciation – [Dr.]
Accumulated depreciation [Cr.]
There are primarily 3 methods of depreciation:
- Straight line method:
Allocation of depreciation charge equally across the life of the asset. For e.g.: if a fixed asset costs $10,000 and has a useful life of 10 years, an amount of $1,000 (10,000/10) will be charged to profit and loss account each year.
- Reducing balance method:
Depreciation is charged at a specified rate, year on year on the reduced value of the fixed asset. For e.g.: the same fixed asset is charged with depreciation at 10% p.a, the depreciation for the first year will be $1,000 (10,000*10%), second year will be $900 ((10,000 – 1,000)*10%) and so on. Depreciation is charged at higher amounts in initial years and keeps reducing each year.
- Units of production method:
Depreciation is charged based on how many units the fixed asset can produce.
Amortization is the allocation of the cost of an intangible asset across its life that is charged periodically to the profit and loss account. Amortization is charged on intangible assets such as patents, trademark, copyrights, goodwill etc.
The amount to be amortized each year depends on the economic or legal life of the intangible asset. For example, a company has obtained a patent costing $1,00,000 which is valid for 20 years. The amount to be amortized each year will be $5,000 (1,00,000/20).
The accounting entry passed for amortization is as follows:
[Dr] Amortization – 5,000
[Cr] Accumulated amortization – 5,000
The amount of amortization is charged to profit and loss account and is also reduced from the book value of the intangible asset
Amortization is generally charged by one method – straight line method.
Differences between depreciation and amortization:
The difference between depreciation and amortization has been detailed below:
- Depreciation is the depletion in value of a tangible asset which occurs due to routine wear and tear during use.
- Amortization is the allocation of the cost of an intangible asset across its legal/economic life.
2. Charged on
- Depreciation is charged on tangible fixed assets including machinery, equipment, furniture, vehicles etc.
- Amortization is charged on intangible assets including patents, copyrights, development rights, mailing lists, trademarks, goodwill etc.
3. Rationale of charge
- Depreciation is to be charged as tangible assets suffer wear and tear as they are utilized in the business.
- Amortization is charged as intangible assets generally have a specific legal term across which economic benefits can be generated.
4. Determined with reference to
- Depreciation to be charged is decided based on its useful life.
- Amortization to be charged is decided based on its economic/legal life.
5. Applicable international accounting standard
- Depreciation of tangible assets is governed by provisions of ‘IAS-16 – Property, Plant and Equipment’
- Amortization of intangible assets is governed by provisions of ‘IAS-38 – Intangible Assets’
6. Residual value
- Charge of depreciation is calculated after considering estimated residual value or salvage value of the tangible assets.
- As intangible assets generally do not have any residual value, the charge of amortization does not consider residual value in its calculation.
- Depreciation can be charged as per several methods including straight line method, reducing balance method and units of production method.
- Amortization is generally charged only on straight line method.
Depreciation vs amortization – tabular comparison
A tabular comparison of depreciation and amortization is given below:
|Depreciation is a charge of part of the cost of a tangible asset to the profit and loss account, determined on the basis of asset’s useful life.||Amortization is a charge of part of the cost of an intangible asset to the profit and loss account, determined basis its legal/economic life.|
|Tangible assets||Intangible assets|
|Rational of charge|
|As wear and tear occurs on use||As intangible assets generate economic benefits over a specific legal term|
|Determined with reference to|
|Useful life||Economic or legal life|
|Applicable international accounting standard|
|IAS-16 – Property, plant and equipment||IAS-38 – Intangible assets|
|Multiple – straight line method, reducing balance method and units of production method||Generally single – straight line method|
Conclusion – depreciation vs amortization
Accurate charge of depreciation and amortization in the books of accounts is essential to reflect true and fair profitability of the business. Accountants and auditors must adhere to the applicable principles laid out in accounting standards and rules while calculating charge of both depreciation and amortization. As all fixed assets have a limited life, the object of depreciation and amortization is to also create a charge in the profit and loss as a provision for replacement of the fixed assets after their useful life is over.