In accounting terms, amortization and depreciation both refer to the devaluation of assets overtime. As an asset loses its value, the loss in value is charged as an expense. The offsetting reciprocal journal entry to the expense is a decrease in the actual assets value. The main purpose for devaluating assets is to create a reduction in the tax liability by reducing net income.
Intangible Assets and Amortization
Amortization in accounting terms means the devaluation of an intangible asset. An intangible asset is something of value to a business that does not have a physical presence. In order to write down an asset, it must have a useful life. The useful life of an intangible is often difficult to determine. Some examples of intangible assets are:
- Patents
- Goodwill
- Contracts
- License
- Trademarks
- Franchise
Fixed Assets and Depreciation
Depreciation in accounting terms normally means the devaluation of a fixed asset. Determining the useful life of a fixed asset is usually much easier then an intangible asset. Since the useful life of fixed assets is much easier to determine, depreciation is much more common than amortization. Some examples of fixed assets are:
- Equipment
- Computers
- Vehicles
- Furniture
- Buildings
Amortization and Depreciation Expense Affect on Net Income
To get a better understanding of how amortization and depreciation affects income, it’s best to see how the transaction is posted to the accounting journal. The following is an example of a typical journal asset for depreciation.
- Depreciation expense – Increase with a debit
- Asset (fixed or intangible) – Decrease with a credit
The journal increase of the expense is transferred to the general ledger. Expense general ledger totals are then transferred to the income statement at the end of the month. The result is a decrease to net income (income – expense). Since the result is a decrease in net income, this creates a decrease in the tax liability of the company. The decrease in the asset is transferred to the balance sheet at the end of the month, resulting in a decrease in the company’s net worth.
Methods of Amortization and Depreciation
There are several methods of devaluating assets. The most common method is the straight-line method. This method of depreciation (or amortization) divides the value of the asset over the useful life of the asset. This results in equal write down amounts over the useful life of the asset.
There are also accelerated depreciation methods that results in larger write-downs in the early life of an asset. This allows a business a larger decrease in the tax burden in the early life of the asset. This is especially beneficial if an asset produces more income in the early stages of its useful life.
There are many rules as to what types of depreciation methods are used depending on numerous factors. Before choosing and implementing a certain method of depreciation, it’s always best to consult a certified public accountant (CPA) to discuss what options are best.
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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