Amortization measures the consumption of the value of an intangible asset, such as a copyright, patent or trademark. In accounting parlance, amortization refers to the deduction of capital expenses over the life of an intangible asset.
Intangible assets are generally expensed according to their life expectancy, but nonphysical assets may have either an identifiable or indefinite useful life. Examples of intangible assets with identifiable useful lives include copyrights and patents, and these are amortized on a straight-line basis over their economic or legal life, whichever is shorter.
Intangible assets with indefinite useful lives are reassessed each year for impairment. If an impairment has occurred, then a loss must be recognized. An impairment loss is determined by subtracting the asset’s fair value from its book value. This impairment loss may be reversed only under certain circumstances. Trademarks and goodwill are examples of intangible assets with indefinite useful lives.
Goodwill must be tested for impairment rather than amortized. If impaired, goodwill is reduced and a loss must be recognized on the income statement.
Depreciation is an expense allocated to a tangible asset’s cost over its useful life. Think of depreciation as the reduction of an asset’s value due to use, passage of time, wear and tear, technological obsolescence, depletion, inadequacy, rot, rust, decay or other similar factors.
Depreciation is the allocation of the historical cost of an asset over the time when the asset is employed to generate revenues. This process of cost allocation has little or no relevance to the market value or current selling price of the asset. It is simply a recognition that a portion of the asset’s cost was used up in the generation of revenues during a given time period.
When used for accounting purposes, amortization and depreciation are noncash expenses that do not affect a company’s cash flow.
Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will reduce taxable profits. There is generally no requirement that depreciation for tax and accounting purposes be treated the same way. Where depreciation is shown on accounting statements, the figure usually does not match the depreciation for tax purposes.
Straight-line depreciation spreads the cost of depreciation evenly over the life of an asset. On the other hand, there are various methods of accelerated depreciation that allow you to deduct more in the first years after purchase. Bonus depreciation is an additional amount of deductible depreciation that is always taken in the first year of an asset’s service. Bonus depreciation may be offered as an incentive or as a measure of relief for small and medium-sized businesses to buy additional equipment.
The depreciation method used for an asset is fixed when the asset is first placed into service. Whatever rules or tables are in effect for that year must be followed as long as you own the asset.
Since depreciation rules have changed many times over the years, you may have to use a number of different depreciation methods if you’ve owned business assets for a long time.