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 their 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.
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. It 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 or more.
The accounting entry passed for depreciation is as follows:
Depreciation – [Dr.]
Accumulated depreciation [Cr.]
There are primarily 3 methods of depreciation:
- Straight line method:
Straight line method allocates depreciation charge equally across the life of the asset. For example, 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. Straight line method is a better choice for computing depreciation of such assets whose utility don’t impair with their use. This is why we often see companies employing straight line method for amortizing their intangibles assets like patents, trademarks etc.
- Reducing balance method:
Under reducing balance method (or written down value method), the depreciation is charged at a specified rate, year on year on the reduced value of the fixed asset. For example, the same fixed asset is charged with depreciation at 10% per annum. The depreciation for the first year will be $1,000 (10,000 × 10%), the second year will be $900 [(10,000 – 1,000) × 10%], the third year will be $810 [(10,000 – 1,000 – 900) × 10%] and so on. Depreciation under this approach is charged at higher amounts in initial years and keeps reducing each year.
- Units of production method:
Under units of production method, the annual depreciation charge is computed based on how many units the fixed asset can produce. For example, Robert Inc. buys an asset for $500,000 which is capable of producing 100,000 units during whole of its life. If the asset is used to produce 2,000 units during the first year of its use, the depreciation to be charged to profit and loss account for the first year would be $25,000 [(500,000/100,000) × 5,000]. This method is preferred by those entities that want to depreciate an asset according to its actual productive use in business.
Amortization is the allocation of the cost of an intangible asset across its life that is charged periodically to the profit and loss account. It 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. As mentioned earlier, the yearly amortization is generally computed by applying straight line method.
Difference between depreciation and amortization
The seven key points of difference between depreciation and amortization have 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.
|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
|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.