As an entrepreneur you know that acquiring and building assets is a pivotal part for your small business's growth. However, those assets come at a cost; and the two main methods for calculating the value of your business's assets over time are amortization and depreciation. The cost of an asset can be depreciated each year over the asset's life. The expense amounts are then used as a tax deduction, lowering the business's tax liability.
That said, learning the difference between amortization and depreciation helps businesses write a numerical value on those assets in terms of their deterioration over time. In this article, we will learn the following:
How are amortization and depreciation different?
What are considered tangible assets and intangible assets?
What can I depreciate in my business?
How do the amortization and depreciation of your assets influence your business accounting?
Let's start with what is the difference between both concepts.
Difference between amortization and depreciation
Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of specific property over its use. It is a provision for the property's wear and tear, deterioration, or obsolescence. On the other hand, you can use amortization to lower the book value of a loan or an intangible asset cost over a period of time. Amortization typically uses the straight-line depreciation method to calculate payments.
What can I depreciate in my business?
You can depreciate most types of tangible property (except for land), including buildings, machinery, vehicles, and furniture. You can also depreciate intangible property, such as patents, copyrights, and computer software.
For an asset to be depreciable, it must meet all the following requirements:
It must be a property you own.
You must use it in your business or income-producing activity.
It must have a determinable useful life.
The asset should last more than one year.
Below are some additional resources from the IRS about the small business amortization and depreciation deduction that you can consult:
Publication 4562 (2021), How To Depreciate Property (Including Information on Listed Property).
IRS Form 4562 (to figure your deduction for depreciation and amortization).
About Publication 538, Accounting Periods and Methods.
What small business owners need to know about the property depreciation deduction.
How to calculate depreciation expenses?
Depreciation is an accounting method that helps establish the expense of using an asset over time (t would be best if you calculate depreciation annually). For example, if you buy some computers for your business, you can depreciate them. The most common method to do it is the straight-line method, and to figure it out, you must understand the following:
The cost of the asset or goods, such as purchase and shipping costs, among others.
The asset's useful life.
The residual value (the asset's value at the end of its useful life).
The following is the formula for calculating straight-line depreciation:
Annual depreciation = (Initial cost of the asset - residual value) / useful life of the asset
For example, the first-year calculation for an asset costing $5,000 with a salvage value of $1,000 and a useful life of 10 years would be $5,000 minus $1,000 divided by ten years, which equals $400.
How to calculate amortization expenses?
Amortization applies to two situations: intangible assets and repayment of a loan. To calculate depreciation, you must first know the value of the asset. Then it would be best if you determined its anticipated useful life, which is the period in which it will be useful to your business. Below is an example of how to calculate the amortization for a patent:
Let's say you bought a patent for $13,000 with a useful life of 10 years.
Annual amortization = Total purchase value of the asset / Estimated useful life of the asset
With this formula, we get
$13,000/10 = $1,300 per year.
Additional resource on how to calculate amortization of loans.
Some key takeaways
This post helped you understand the critical components associated with amortization and depreciation of your assets. Below are some of the key points:
Amortization is fundamentally writing off the value of an intangible asset or a loan.
Amortization helps small businesses record costs for an intangible asset such as software, a patent, or copyright.
Amortization expense is the cost of long-term assets, which gradually decreases over time.
Depreciation expense is the cost of an asset depreciating over a single period. It shows how much of the asset's value declined that year.
Tracking the depreciation expense of an asset is essential for tax reporting purposes.
If you can depreciate intangible property, you usually use the straight-line depreciation method.
Disclaimer: This material has been prepared for informational purposes only. It is not intended to provide and should not be relied upon for tax, legal, or accounting advice. We suggest consulting with your tax, legal, and accounting advisor before making any transaction.