Every company has some assets. Few of the assets over time become useless. The assets that are not having a lifetime guarantee, therefore their costs are calculated over a period of time when they can be used. The proper method of calculating the cost of assets over the useful life is known as depreciation or amortization. There are basically two types of assets – Tangible and Intangible Assets. Depreciation deals with tangible assets, whereas, amortization deals with intangible assets.
What is Depreciation?
Physical assets are tangible assets. A tangible asset (physical asset) can be perceived through five senses. The expense of tangible assets over a useful period of time is known as depreciation. A few of the tangible assets that are depreciated are listed below:
- All sorts of machinery
- Furniture for office use
The above given tangible assets have some value at selling time as well. Depreciation of any tangible asset is calculated by subtracting the resale value from the original cost.
For Example, A building is used for office purposes for many years and then it is sold by the business owner. The actual cost of the whole building is evenly spread out over the predicted life span of a building with a specific portion of the cost that is being expensed in each year’s accounting.
Another type is accelerated method depreciation. It means that a large portion of the value of the asset is expensed in the starting years of its lifecycle. One of the most common examples of accelerated depreciation method is of vehicles.
What is Amortization?
The intangible assets are known as non-physical assets. Amortization is the process of spreading the cost of an intangible asset over a useful period of time.
For amortization, the exact same amount is expensed at each stage over the asset’s life. They usually do not have any resale value like depreciation assets.
Below are the examples of intangible items:
- Organizational costs
How does Amortization Affect a Balance Sheet?
A specific portion of an asset’s cost is recorded on the income statement in each accounting period over the asset’s life. The cost of intangible assets is recorded in the assets section of the balance sheet. The cost is recorded only if it is purchased from another party and it has a finite life.
The annual amortization expenses of intangible assets reduce the value on the balance sheet. As a result, the total assets’ amount is also reduced in the assets section of a balance sheet. This cycle keeps moving till the life of the intangible assets.
As an example, An intangible asset has a five-year life period with a $500 annual amortization expense. Therefore, its value on the balance sheet will be reduced by $500 annually for five years, which in return will also reduce the assets by $500 annually.