Depreciation and amortization are accounting techniques used for a range of purposes. Although the way these two techniques are calculated is similar, their core purposes are quite different. Both depreciation and amortization can be calculated using a variety of methods, each of which features unique accounting benefits suited for specific situations.
Depreciation Schedules
Depreciation is a method of recognizing large expenses in small parts in an accounting system. The concept of depreciation deals with the fact that assets lose their value over time, eventually ending up at a salvage value—the value at which the asset can be sold at the end of its useful life. Depreciation as an accounting tool recognizes a large expense in portions equal to the amount that the asset has gone down in value for the period.
Amortization schedules calculate the principal and interest payments on bonds and loans using either a fixed or variable interest rate. Amortization schedules recognize a different ratio of interest and principal payments for each period, with portions increasing for principal payments over time, even though the actual periodic payment may be the same.
Depreciation Methods
The concepts of depreciation and amortization apply to a range of investments. Depreciation is used for productive and real assets, such as machinery and buildings. Amortization is used for bonds, to calculate the carrying value of the bonds at a specific time given the amount of interest that has already been paid and the amount yet to be paid. Amortization is also used to create mortgage repayment schedules.
Straight-Line Depreciation Calculation
The straight-line method of depreciation and amortization is the simplest form to calculate. The straight-line method calculates a fixed periodic installment for expense recognition or loan repayment. Calculating installments with the straight-line method involves dividing the principal payment by the number of payment periods, and multiplying the remaining principal balance by the periodic interest rate each month.
Double Declining Depreciation Calculation
The declining balance method is used exclusively for depreciation. This method assumes that the value of an asset will decrease by larger amounts in each period of use, making equal depreciation amounts inadequate to represent the true value of the asset. Calculating depreciation using the declining balance method involves multiply the current book value by a pre-determined depreciation rate each period to determine the appropriate depreciation expense.
Benefits of Depreciation and Amortization
Depreciation allows companies to avoid recognizing large expenses in a single accounting period, allowing them to keep income and profit figures under control. This is crucial for publicly traded companies, who rely on their financial statements to attract investors and lenders.
Amortization helps borrowers and lenders to plan payments for bonds and loans, giving borrowers a clear picture of exactly what must be paid each month to repay the debt on time, and how much interest will be incurred if payments are structured over alternative periods.
Dave Ingram - David Ingram has spent several years writing case studies on all aspects of international business, specializing in marketing and ...
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