Amortisation

Amortisation is a practice that helps spread the cost of an intangible asset over a specific period, which is usually the course of its useful life. It occurs on a straight-line basis, wherein a fixed amount gets deducted regularly from the value of assets like patents and trademarks, copyrights, franchise agreements, etc. When an asset gets amortised, it does not have any resale or salvage value at the end of its useful life. For example, a company obtains a license valued at Rs. 40000 and it will expire in 5 years. Since that license is an intangible asset, the company should amortise it for the 5-year period till its expiry date. In the Straight Line Method, the annual amortisation expense for the license gets calculated as Rs. 8000 (Rs. 40000/5 years), which means that the asset’s value will decline by Rs. 8000 every year.

Depreciation

Depreciation is a practice that helps to spread the cost of a tangible asset over a specific period, which is usually the course of its useful life. The primary purpose of depreciating an asset is to match the expense of purchasing it with the income it can generate for the company. Physical assets like plants, furniture, machinery, land, buildings, etc., are subject to depreciation. These assets might have resale or salvage value at the end of their useful life. The depreciation amount is calculated by first deducting the asset’s salvage value from its original cost. The amount gets computed using one of the two methods (Straight Line Method or Written Down Value Method) to determine the amount the company will deduct on a year-to-year basis from the asset’s value.

Under the Straight Line Method, a fixed amount is deducted from the value of an asset every year over its useful life. It is also known as the ‘Original Cost Method’ or the ‘Fixed Installment Method’. For example, a company obtains machinery valued at Rs. 100000 with a useful life of 10 years. In the Straight Line Method, the annual depreciation amount for the machinery gets calculated as Rs. 10000 (Rs. 100000/10 years), which means that the asset’s value will decline by Rs. 10000 every year.

But in the case of the Written Down Value Method, the yearly depreciation amount is calculated using a fixed percentage. In this method, the depreciation amount is higher for the initial reporting periods compared to the later reporting periods. This method is also known as the ‘Diminishing Balance Method’ or the ‘Reducing Installment Method. For example, a company obtains furniture for Rs. 50000, and the depreciation rate is 10%. Using the written down value method, the depreciation amount for each year would be as follows:

First year = Rs. 5000 [10% of Rs. 50000],

Second year = Rs. 4500 [10% of (Rs. 50000 – Rs. 5000)],

Second year = Rs. 4050 [10% of (Rs. 45000 – Rs. 4500)], and so on.

Differences between Amortisation and Depreciation

Some of the significant differences between Amortisation and Depreciation are as follows:

Conclusion

The debate on Amortisation vs Depreciation ignores the fact that they help write down the value of an asset in the account books. Both these methods are helpful for any organisation that wants to expense these assets over their useful lives proportionally.

Also See:

• 5 Limitations of Financial Analysis
• Advantages of SLM and WDV for Calculating Depreciation