Amortization Vs. Depreciation - Why It Matters to Business

10
February 2022

Two ways of determining the worth of your company assets in time are amortization and depreciation. These expenses can be calculated to claim them as a tax deduction and lower the tax burden of your small business. As a business owner, you should learn these two accounting terms. That way, you understand what the money professionals are talking about, and you can alert them to things that might reduce your taxes.

What’s the difference between amortization and depreciation?

Business assets are deductible business expenses. Amortization and depreciation are two methods of calculating value for business assets and enabling you to reduce your business's tax liability. The difference between amortization and depreciation is that they apply to different types of assets.

Amortization is the accounting method of amortizing the cost of an intangible asset over its useful life. Examples of intangible assets to be amortized into expenses of a business:

  • Patents & trademarks

  • Copyrights

  • Intellectual Property

  • Research & Development

  • Organizational costs

  • Proprietary information (such as recipes, design processes, and algorithms)

On the other hand, depreciation is expensing a fixed asset throughout its useful life -an estimated number of years it will be profitable to operate. A company's fixed assets are tangible assets that were purchased, for example:

  • Building

  • Machinery

  • Vehicles

  • Computers

  • Furniture

  • Livestock

Use the IRS resources and Instructions to Form 4562 to claim your deduction for depreciation and amortization (Including Information on Listed Property).

How to calculate amortization expense?

To calculate amortization, first, you need to know the asset's value. Next, you need to determine its anticipated helpful life span - the period you anticipate the asset being of use to your business. Divide the life span by the asset's value. For example:

Total cost of the asset/Useful life in years =Annual Amortization Expense

We'd strongly advise you to let a financial professional calculate amortization expenses. Since you can claim the same amount over the useful life of the asset, it's easier to have the calculation done so that you can expense it with confidence.

Also, note that asset amortization is different than a loan amortization schedule. When referencing loans, an amortization schedule can be used to calculate loan payments consisting of principal and interest. Using this process, you pay off interest early in the loan's lifetime, and subsequent payments are increasingly applied to the principal. The most common examples of this usage are mortgage or auto loan payments.

How to calculate depreciation?

Depreciation is similar to amortization; the big difference is that you are dealing with tangible assets. So, if you own an asset, you use it in your business, it will eventually wear out or need to be replaced, you can calculate its anticipated useful life, and you expect it to be useful for more than a year, you can probably depreciate ("write off") part of the cost of those assets over a period of time.

There are three different methods to calculate depreciation:

Straight-Line Depreciation: Simple to figure out, but slowest deprecation write-off.

(Cost of Tangible Asset-Salvage Value)/Useful Life = Annual Depreciation

Accelerated Depreciation: The method used by most small businesses, you get a more significant write-off in the beginning years, and the write-off dwindles over the useful life of the asset.

Bonus Depreciation: Bonus depreciation allows firms to deduct a significant portion of the cost of qualified purchases in the year they are made, rather than depreciating them over time.

Woman Calculating her business's amortization and depreciation deductions

The IRS allows you to depreciate specific items over a set period of years. Check the information in IRS Publication 946 on How To Depreciate Property for exhaustive details on what property can be depreciated and how to calculate the write-off.

Here is a general summary and with many exceptions:

  • Three years: Tractors, tools, and some livestock (specifically, racehorses)

  • Five Years: Computers, office equipment, cars, light trucks, and construction equipment.

  • Seven years: Office furniture, appliances, vehicles, and assets that don't fall into other categories (apart from real estate). You are allowed to write off real estate over a more extended time period; 27.5 years (residential rental properties) and 39 years (commercial buildings).

Assuming you are not a financial whiz, you need professional advice – or at least a tax preparation program that you trust - to figure out how to best calculate depreciation. At the risk of boring you, we'll repeat this: general tax advice applies only to a point. It is essential to talk to a financial professional to understand calculating and expense amortization and depreciation deductions.

How to Access Fast Working Capital?

If you are ready to invest in your business by adding new assets or replacing those nearing the end of their useful lifespan, you probably need working capital. Sadly, owners of smaller companies often struggle to access working capital from bank loans – the application process is complex and demanding, and requirements are strict.

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