When it comes to acquiring new assets for a company, it is vital to understand how their cost can be appropriately expensed over a certain period of time.
However, not everyone is aware of the concept of amortization vs. depreciation. Even fewer people know the difference between the two or how they work. For this reason, we will provide insightful examples so that you can understand this concept better.
Key Points
- What is Amortization?
- What is Depreciation?
- Different Ways to Calculate Depreciation
- Comparing Amortization and Depreciation
- Our Takeaway
What Is Amortization?
When thinking about the definition of amortization, the concept of spreading out debt or loans over a specific period of time comes to mind. This is done by dividing the total cost of debt or loan by the number of monthly payments you will make. As a result, you will obtain the amount you need to pay each month in order to amortize the debt or loan.
For example, let’s say you borrow $20,000 to purchase a new car. At this point, the amortization cost for each month amounts to $833.33. This means that the total cost of the loan ($20,000) is divided by the number of monthly payments you will make (24).
Apart from business assets, the amortization can also be used for home mortgages and student loans—Americans owe more than $1.71 trillion in student loan debt.
What Is Depreciation?
Depreciation is a method of accounting for the wear and tear of assets over time. Contrary to amortization, depreciation is done by subtracting a set amount from the asset’s value each year, giving you an estimate of how much the investment is worth at any given time.
However, in the next section, you will see how to calculate depreciation.
Different Ways to Calculate Depreciation
There are a few different ways to calculate depreciation, but the most common is the straight-line method. In this case, the depreciation for each year is calculated by subtracting the same amount from the original value of the asset.
For example, let’s say you buy a new car for $20,000 in 2022. You plan to keep the car for four years, and during that time, it will depreciate by $4,000. Here’s how:
With the straight-line method, the depreciation for each year would be calculated as follows:
- Year 2022: $4,000 (the amount to be subtracted from the original value)
- Year 2023: $3,600
- Year 2024: $2,800
- Year 2025: $2,000
After four years, the car will be worth $8,000 (the original purchase price minus the depreciation).
Comparing Amortization and Depreciation
After exploring some amortization vs. depreciation examples, it is time to dig deeper into their similarities and differences.
Similarities Between Amortization and Depreciation
First of all, both amortization and depreciation are ways of calculating the value of an asset over a specific time. Moreover, they both subtract a set amount from the original value of an asset each year.
Overall, amortization and depreciation are very similar accounting methods for the value of an asset over time, so it’s understandable how many people easily confuse these two concepts.
Differences Between Amortization and Depreciation
While amortization is always a set amount, depreciation can vary depending on how much the asset is used. Another notable difference involves how amortization in accounting is paid overtime, while depreciation is taken as a reduction in the value of an asset each year.
As mentioned earlier, amortization is used to repay a debt or loan. On the other hand, depreciation is used to account for the wear and tear of an asset.
Amortization vs. Depreciation: Our Takeaway
Is amortization or depreciation a better decision for your business? While depreciation is usually more advantageous for a company, that doesn’t mean it’s always true for every business out there. That’s why it is crucial to understand how amortization and depreciation work before proceeding with any decision.
However, it is recommended to always consult with an accountant to get specific advice for your situation.
Frequently Asked Questions
Is depreciation a fixed cost?
Depreciation is a fixed expense, as it occurs at the same rate every year during the asset’s useful life.
Contrary to what you might believe, depreciation is not a variable expense because it does not change with the level of activity. There is, however, one exception. In this case, depreciation will be incurred in a manner that is more consistent with a variable cost if a company uses a usage-based depreciation technique.
What is the difference between amortization and depreciation schedule?
There is no real difference between an amortization and a depreciation schedule. They are both ways of calculating the value of an asset over time. However, an amortization schedule is typically used to track the repayment of a loan, while a depreciation schedule is used to track the depreciation of an asset.