Last editedMay 20222 min read
Depreciation and amortization play key roles in business accounting and bookkeeping. Knowing what they refer to as well as how to forecast them is therefore important for small and large businesses alike.
Indeed, in order to determine your financial statements, either historical or forecasted, you need to calculate both depreciation and amortization. Business plans will therefore require you to calculate depreciation and amortization.
In this article, we’ll define the terms depreciation and amortization and outline the respective depreciation and amortization formulas. That way, you’ll gain a good idea of how to forecast depreciation and amortization for yourself.
What is depreciation?
Depreciation refers to the reduction in the value of an asset over time, typically due to wear and tear. Measuring the loss in value over time of a fixed asset, such as property or equipment, is called depreciation.
Depreciation is considered an expense in business terms and is noted as an expense on income statements.
Property and vehicles used in a business can be depreciated, as well as equipment, furniture and machinery. Land, however, is not considered an expense and, as such, cannot be depreciated. Indeed, land does not suffer wear in tear in the same way as a vehicle or piece of equipment does.
How to calculate depreciation
In order to calculate the annual depreciation of your assets, you need to know the initial cost of the asset, i.e. how much you paid for it when you purchased it. You also need to predict how many years the asset will remain a value to the business. You then divide the initial cost by the amount of time the asset will remain useful.
The formula for depreciation:
For example, say you bought a delivery truck for use in your business for $100,000. As soon as you leave the dealership, the truck begins to lose value. Every year it is used by the company it goes down in value, but you predict it will remain useful for 10 years.
100,000/10 = 1000
Therefore, your truck depreciates by $1000 per year.
This formula can be applied to forecast depreciation.
What is amortization?
Amortization is an accounting technique which is used to lower the value of a loan or intangible asset over a predetermined period of time. With loans, for instance, amortization involves the spreading out of repayments at set intervals. With assets, however, amortization functions in a very similar way to depreciation.
With intangible assets, the amortization formula resembles that of depreciation. It involves dividing the initial cost of the intangible asset by its predicted useful life. In this way, you can forecast amortization.
For example, if a trademark costs $20,000 to acquire, and will be useful for a decade, the amortized amount equals $2,000.
On a balance sheet, accumulated amortization is marked as a deduction under the amortized intangible asset.
How does depreciation differ from amortization?
Given their near identical calculations, you may be wondering what the difference is between depreciation and amortization. In fact, depreciation only refers to physical or tangible assets, such as vehicles and property. Amortization, meanwhile, refers to the depreciation of intangible assets, such as intellectual property, like patents or trademarks.
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