Amortization may be defined in two ways:
- It represents paying off a debt which has fixed repayment schedule over several time periods made for regular installments.
- It represents distributed over time capital expenses for intangible assets for accounting and tax purposes.
In general, amortization is defined by payments spread over various periods.
Types of amortization
The term amortization can be applied for two independent processes, as mentioned above:
- Amortization of loans – it means distributing the payment into more than one cash flow sections, as instructed by an amortization schedule. After that, payments are spread in equal amounts over the duration of the loan in order to make the best repayment model. If the payments for a loan do not fully cover the interest due, the remaining amount is added to the loan balance and the original amount of loan becomes larger. This is called negative amortization.
- Amortization of intangible assets – this meaning of amortization is about expensing the procurement cost minus the leftover value of intangible assets, such as intellectual property like patents, in a systematic way over their predicted economic lives as useful items, in order to show their consumption, estimated expiration date, obsolescence, or further decrease of the value as a result of usage or passing time.
Depreciation is very similar to amortization, but they don’t have the same meaning. Depreciation represents a systematic allocation of the cost from a fixed asset over its useful life. Its purpose is to give more realistic image about profitability of the entity. If there were no depreciation, the whole cost of a fixed asset would be recognized in the year of purchase.
Difference between depreciation and amortization
To simplify the purpose of the amortization and depreciation, they can be defined as tools for prorating the cost of a specific type of asset over the asset’s life. This is the reason why those terms are sometimes considered synonyms. However, there are some differences between them.
Amortization typically relates to cost of an intangible asset spread over its useful life. For example, the cost of creating the asset is spread out over its estimated life and recorded as an expense on the company’s income statement.
Compared to amortization, depreciation refers to prorating a tangible asset’s cost over its life. It refers to material things which company needs in order to do its job – office, machines etc. The main principle is the same. The cost of the asset is spread out over the predicted life of it, and the portion of the cost is expensed every accounting year.