What is Amortization or Depreciation? Distinguish between Amortization and Depreciation

Amortization or Depreciation is a method of gradually distributing the costs of a business asset over the life of that asset.

What is amortization

Amortization is a method of gradually distributing the costs of a business asset over the life of that asset.

amortization

In English, both Amortization and Depreciation are depreciation. The main difference between them relates to what type of asset is being depreciated.

Amortization of intangible assets

Depreciation of intangible fixed assets – noun, referred to in English as Amortization.

Depreciation of an intangible asset is a method of gradually distributing the cost of using an asset over its life cycle. Intangible fixed asset is a type of asset other than physical assets. Examples of intangible fixed assets depreciated under this method are:

• Patents and trademarks

• Franchise Agreement

• Exclusive formulas, copyrights

• Cost of issuing bonds to increase capital

• Organization expenses, establishment costs

Depreciation of tangible fixed assets, unlike tangible fixed assets, amortization is usually amortized on a straight-line basis. That is, for each stage in the life of an asset, an equal amount of costs are deducted. In addition, depreciated intangible assets generally have no resale or carrying value as they would when depreciating tangible fixed assets.

See also: What is inventory turnover? Meaning of Inventory turnover

Tangible fixed assets depreciation (Depreciation)

Tangible fixed asset depreciation – noun, English known by the word depreciation.

Tangible fixed asset depreciation is the method of distributing the costs of a fixed asset over its useful life. Fixed assets or tangible fixed assets are physical assets that can be touched. Some examples of tangible fixed assets that are often depreciated are:

• House

• Equipment

• Office furniture

• Vehicle

• Land

• Machines

Since tangible fixed assets often have a residual value at the end of their useful life, the depreciation method for tangible fixed assets is calculated by subtracting the asset’s initial cost of the asset. remaining (or resale cost).

Another difference is that depreciation of tangible fixed assets is evenly distributed each year over the expected life of the asset. In other words, the annual amortization expense is a tax deduction for the business until the end of the intended life of the asset.

For example, an office building might be used for many years before being decommissioned and sold. The cost to use the building is divided equally by its intended years of use, and each portion of the cost is recorded each year.

Some tangible fixed assets can be amortized using the accelerated depreciation method, meaning that a large portion of the asset value will be amortized in the first years of use. For example, vehicles are often depreciated using the rapid depreciation method.

Special note

Depreciation is another way of accounting for the cost of a business asset. This approach involves the allocation of the natural resource use cost over time. For example, an oil well will often have a finite time to produce it before it runs out. Therefore, the cost of setting up the well will be evenly distributed over the estimated useful life of the well.

Depreciation of tangible fixed assets, amortization of intangible fixed assets and amortization are three types of non-cash costs because there is no need to spend cash to account these costs. It is also important to note that in some countries, eg Canada, the concepts of Amortization and Depreciation can be used interchangeably to refer to both intangible and tangible assets.

Meaning of depreciation

Do you have to question why amortization must be calculated when its cash value is still in the company pocket? Actually, they have a very important meaning.

Economy

To make it easy to understand, imagine a self-driving car rental company wants to sell a car they bought for $ 900 million, now they are 5 years old. In order to calculate the present value and sell it at a fair price, they would have to rely on depreciated expenses. Subtracting the 5-year depreciation cost of 300 million, they can sell this car for less than 600 million.

In addition to the significance in the valuation when reselling, depreciation also helps the company determine the depreciation of an asset to plan to change or renew the asset.

Financially

Depreciation affects the cost of the product that a company sells because depreciation is the amount of depreciation of that product. Knowing depreciation will help the company focus capital from the depreciation fund to renew assets.

Depreciation calculation methods

If you follow the concept of depreciation mentioned above, many people will think that the method of calculating depreciation is simply dividing the value of the asset by the expected time of use. This is true but not enough, there are 3 ways to calculate depreciation as below:

Straight line depreciation method

Formula: Annual depreciation cost = Historical cost of fixed assets / Time of depreciation

In case the historical cost of a fixed asset changes or the time of depreciation changes, the depreciation cost must be recalculated using the following formula:
Remaining depreciation cost = Residual value of fixed assets / Remaining time of depreciation

Decreasing balance depreciation method

Annual rate of depreciation of fixed assets = Residual value of fixed assets x Rapid depreciation rate

Inside:

Rapid depreciation rate (%) = Straight-line depreciation rate of fixed assets x adjustment coefficient.

Straight-line depreciation rate of fixed assets (%) = (1 / Time of depreciation of fixed assets) x 100

The adjustment coefficient is determined by the time of depreciation of fixed assets specified in the following table:

Time of depreciation of fixed assets Adjustment factor (times)
Up to 4 years (t <= 4 years) 1.5
Over 4 to 6 years (4 years < t < = 6) 2.0
Over 6 years (t > 6 years) 2.5

Product volume depreciation method

Formula: Monthly rate of depreciation of fixed assets = Number of products produced in month x Average rate of depreciation per unit of product.

Inside:

Average rate of depreciation per unit of product = Historical cost of fixed assets / output by design capacity.

The above article Fastloans.PH has explained in detail what depreciation is and what to know about depreciation. Hope to help you have a better understanding of this concept and avoid confusion with other similar concepts in accounting.

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