Depreciation vs. Amortization 

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Contributor, Benzinga
August 10, 2023

Assets tend to lose their value with wear and tear. Real estate properties need repairs to maintain their value, and many companies rely on intangible assets like copyrights. Depreciation and amortization attempt to pinpoint the fair value as these assets get older. Calculating depreciation and amortization can help you save money on your tax bill. This guide will walk you through the differences between these two valuation methods and how to calculate the current value of your asset.

What is Depreciation?

Depreciation is the process of deducting a tangible asset’s value over its useful life. Some investors conduct this calculation by deducting an asset’s salvage value from its original purchase price. Salvage value represents the amount you could receive from an asset if you decided to resell it. Depreciation is a tax deduction, so it benefits investors to state their assets have gone through higher depreciation. However, you cannot depreciate an asset further if you have already depreciated all of its value through this accounting trick.

Depreciation Methods

Investors can use several depreciation methods to arrive at their calculations. These are the top choices to consider:

  • Straight-Line Method: This method uses a fixed amount of depreciation every year through the asset’s useful life. If you depreciate $5,000 from an asset this year with the straight-line method, you will also depreciate $5,000 from the same asset next year.
  • Declining Balance: Depreciation is based on a fixed percentage rather than a fixed value. That means depreciation will be higher earlier in the asset’s useful life.
  • Double Declining Balance Method: The same method as the declining balance method, but an investor doubles the total depreciation each year. This strategy results in faster depreciation of the asset. You get higher initial tax breaks but burn through the asset’s useful life sooner.
  • Sum-of-the-Years' Digits Method: An investor determines an asset’s useful life and calculates its sum in years. For instance, an asset with a three-year useful life has a sum of six (3 + 2 + 1 = 6). This sum becomes the denominator for each of the years. In Year 1, the depreciation rate is 3/6. In Year 2, the depreciation rate is 2/6. In Year 3, the depreciation rate is 1/6. The total adds up to 6/6, representing 100% depreciation at the end of the asset’s useful life.
  • Units of Production: An investor considers how much utility they want to get out of an asset before deeming an end to its useful life. If you want to drive 200,000 miles in a vehicle, and you drive 20,000 miles this year, the depreciation rate for that year is 10%. 

What is Amortization?

Amortization involves taking an intangible asset and spreading its cost over its useful life. It’s similar to depreciation but specifically applies to intangible assets, such as goodwill. Most investors use the straight-line method when calculating amortization over several years. 

Comparing Depreciation and Amortization

Depreciation and amortization are both similar ways to reduce an asset’s cost and capitalize on tax deductions. These are some of the key factors to know about each approach.

The Type of Asset

Depreciation applies to physical assets with tangible value. Real estate, art and machinery are some of the assets that fit this category. Amortization is specifically for intangible assets, such as a brand’s image, copyrights and trademarks.

Choices

Investors using amortization are stuck with the straight-line method. However, investors using depreciation can choose from several methods that impact short-term and long-term depreciation values. You can have an asset depreciate at a higher rate if you want higher upfront tax deductions.

Salvage Value

Depreciation calculations deduct the salvage value from the asset’s purchase price. However, intangible assets do not have salvage value, so it is not deducted from their value when conducting amortization calculations.

Speed of Decay

Amortization uses the straight-line method, which results in steady write-offs over time. However, investors have multiple ways to calculate depreciation and can intentionally speed up the depreciation of an asset. Accelerating depreciation allows investors to capitalize on higher tax deductions during the initial years of an asset.

Mentality

Amortization refers to spreading an asset’s cost over time and using write-offs. Depreciation involves diminishing an asset’s value and using it as a tax deduction. Amortization and depreciation both help investors save money.

Turn Your Assets into Tax Deductions

Depreciation and amortization help investors turn their assets into tax write-offs. Savvy investors can use these costs to increase cash flow and generate higher returns on their investments.

Frequently Asked Questions 

Q

Are depreciation and amortization included in operating expenses?

A

Depreciation and amortization are both included in operating expenses.

Q

Can depreciation and amortization be positive?

A

Depreciation and amortization can be positive.

Q

How can depreciation and amortization be a source of cash?

A

Depreciation and amortization can be a source of cash because they are tax write-offs. These deductions lower your taxes and increase your cash flow in the process.

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