Introduction
Business assets usually cost a fortune and have a limited lifespan. Hence, it is necessary that this cost be expensed proportionately across their functional life. Depreciation and amortization are two such accounting processes that involve spreading out the cost of these assets throughout their useful life.
Before understanding how these two methods work, let us understand what business assets are.
What are Business Assets?
Business assets refer to items of value owned by firms/companies, etc. Assets play a vital role in increasing productivity, revenue and efficiency.
Based on physical characteristics, the assets of a business are of two types:
- Tangible Assets: Tangible assets refer to those resources that have a physical form. Examples of tangible assets include plant, building, machinery, etc.
- Intangible Assets: Intangible assets are resources without any physical form. Trademarks, patents, goodwill are examples of intangible assets.
Now let’s find out how depreciation and amortization works.
Understanding the Meaning of Depreciation and Amortization
In simple terms, depreciation refers to the reduction in a tangible asset’s monetary value due to prolonged usage. This accounting technique enables businesses to spread the cost of their fixed assets over the span of their useful life. This allocation is reflected in the business’s profit and loss account for the particular financial year.
On the flip side, amortization refers to the reduction in the monetary value of intangible assets over time. It involves prorating the cost of intangible assets over the course of their useful life. Similar to depreciation, amortization appears as an expense in the income statement or profit and loss account of a business.
Why are depreciation and amortization shown in the income statement?
As per Indian Accounting Standard 6, “The depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset.” This is because the annual depreciation of an asset is an expense, and hence, is a charge on profits.
Similar rules are applicable on amortization as well, as mentioned in Indian Accounting Standard 38.
Common Methods of Computing Depreciation and Amortization
Here are some popular methods that businesses use to calculate depreciation and amortization:
Straight Line Method
When a business opts for the straight-line method, the depreciation is spread out evenly over a period until the salvage value is reached. In other words, if a company computes depreciation using this process, the depreciation expense will be the same in each year over an asset’s lifespan. Note that salvage value refers to the estimated book value of tangible long-term assets at the end of their useful life.
The straight-line method is the most straightforward process of distributing the cost of business assets over their useful life.
Example 1: Amortization Using Straight Line Method
Suppose Company XYZ has a patent worth ₹15,00,000 expiring in 30 years. But since the patent’s estimated useful life is 15 years, note that the amortization interval must be 15 years.
To compute the amortization of the patent, the company has to divide the patent’s cost price by its estimated useful life.
Therefore, the amortization of XYZ Company’s Patent will be ₹15,00,000/ 15 = Rs. 1,00,000
Example 2: Depreciation Using Straight Line Method
Let’s say ABC Company purchased a machine worth ₹50,00,000 to manufacture garments. The estimated lifespan of this machine is 10 years, and its salvage value is 10% of the cost price.
ABC can compute the value of depreciation using this formula:
Depreciated Value = Machine’s Purchase Price – Salvage Value
= ₹(50,00,000 – 5,00,000)
= ₹45,00,000
Now, considering that the useful life of the machine is 10 years, the calculation of depreciation per year will be as follows:
Annual Depreciation = ₹45,00,000/10
= ₹4,50,000
Reducing Balance Method
The reducing balance (or written down value) method involves charging depreciation based on the previous year’s closing balance of an asset. Closing balance refers to the credit/debit balance of an account at the end of an accounting period.
To calculate closing balance, businesses have to deduct the previous year’s depreciation from the asset value. Under this method, the profit for a financial year will be lower in the first few years. But in the later years, it will be higher.
Generally, a company uses the same method for computing amortization as well as depreciation. That said, note that amortization schedule is used in the case of loans.
Example 3: Depreciation Using Reducing Balance Method
Some companies use the reducing balance method to compute depreciation instead of the straight-line method. Here’s an example to explain this method:
Let’s say ABC purchased new machinery worth ₹5,00,000 to increase production and strengthen its top line. As per the manager, this machine’s estimated useful life is 10 years, and salvage value is ₹10,000. The depreciation rate is 20%
ABC can use the following calculation to ascertain the amount of depreciation resulting from regular usage:
Depreciation Percentage x Annual Depreciation Amount
|
Year
|
Depreciation Calculation
|
Amount of Depreciation (₹)
|
Value at the End of the Year (₹)
|
|---|---|---|---|
|
1
|
20% of ₹(5,00,000 – 10,000)
|
98,000
|
4,02,000
|
|
2
|
20% of 4,02,000
|
80,400
|
3,21,600
|
|
3
|
20% of ₹3,21,600
|
64,320
|
2,57,280
|
|
4
|
20% of ₹2,57,280
|
51,456
|
2,05,824
|
|
5
|
20% of ₹2,05,824
|
41,164.8
|
1,64,659.2
|
|
6
|
20% of ₹1,64,659.2
|
32,931.84
|
1,31,727.36
|
|
7
|
20% of ₹1,31,727.36
|
26,345.47
|
1,05,381.89
|
|
8
|
20% of ₹1,05,381.888
|
21,076.38
|
84,305.51
|
|
9
|
20% of ₹84,305.5104
|
16,861.10
|
67,444.41
|
|
10
|
20% of ₹67,444.40832
|
13,488.88
|
53,955.53
|
Key Differences between Depreciation and Amortization
This table represents a head-to-head comparison of depreciation and amortization:
|
Basis of Comparison
|
Depreciation
|
Amortization
|
|---|---|---|
|
Definition
|
Depreciation is an accounting technique for computing the reduced net worth of tangible fixed assets. The reduction in cost price over an asset’s life is proportional to its usage in a particular year.
|
Amortization is an accounting technique that measures the reduction in the value of intangible assets.
|
|
Implementation Method
|
Accountants can use the straight-line method or the declining/reducing balance method to compute depreciation. Note that there are other methods of calculating depreciation as well.
|
In most cases, one can use the straight-line method for computing amortization. Businesses can use other methods such as reducing the balance to compute amortization.
|
|
Salvage Value
|
The salvage value of the fixed asset is taken into account when computing depreciation.
|
Unlike tangible assets, intangible assets usually have no salvage value. Accordingly, amortization is calculated using the full value of the intangible asset.
|
|
Formula
|
Annual Depreciation = The Cost of the Tangible Fixed Asset ÷ Useful Life
|
Annual Amortization = The Cost of the Intangible Asset ÷ Useful Life
|
|
Depreciation
|
Depreciation is a charge against profit. Accordingly, it is a debit entry (an accounting entry that increases an expense or asset account). Simultaneously, the accumulated depreciation account is credited with the same amount.
|
Similar to depreciation, amortization is an expense. Thus, it is a debit entry. Simultaneously, the accumulated amortization account is credited with the same amount.
|
Final Word
It is crucial for businesses to account for both these non-cash expenses every financial year. After all, assets have a limited lifespan and must be replaced eventually to avoid manufacturing downtime. A business, irrespective of its size, must comprehend the essentiality of depreciation and amortization and understand how it should set sufficient funds aside to finance the purchase of an asset, when necessary, in the future.
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