You have been Successfully Subscribed to Newsletter
You have been Successfully Subscribed to Newsletter
Learn more about the key difference between amortisation and depreciation, their distinct applications and implications in financial management.
When a business acquires an asset with a prolonged useful lifespan, like a vehicle, trademark or even a patent, it is done to provide ongoing benefits rather than just at the point of acquisition. To accurately portray the utilisation of these assets, businesses choose to spread out the cost of these assets over their useful life, expensing a portion each year. These expenses serve as tax deductions, effectively reducing the business's tax liability.
In the accounting space, amortisation and depreciation are two approaches used to evaluate an asset’s value over its lifespan. While the two concepts can sound similar to you, there is a distinct difference between amortisation and depreciation stemming from the nature of the asset being expensed, their methodologies, and their depiction on financial reports. Let's find out.
Amortisation is the practice of allocating the cost of an intangible asset across its useful lifespan. These intangible assets can vary from patents, copyrights, franchise agreements, goodwill, etc. It involves allocating the initial cost of these assets to expense gradually over time, reflecting their decreasing value as they are consumed in the business operations.
On the other hand, depreciation is the process of expensing the cost of tangible assets, like buildings, machinery, vehicles, or even furniture over their estimated useful lives. Depreciation accounts for the wear and tear, obsolescence, and reduction in the value of these tangible assets as they are used in the production of goods or provision of services. Unlike intangible assets, tangible assets retain a part of their value after cessation of business use. Therefore, depreciation is calculated by deducting the asset's salvage or resale value from its original cost. This value is then depreciated over the anticipated years of asset usefulness and serves as a tax deduction for the business until the asset's usability concludes.
Calculating the cost of intangible assets can be a little hard to define because they do not have any resale value. So let’s use an example to help you understand how amortisation works:
Suppose your company purchases a patent for ₹1,00,000 with an estimated useful life of 10 years, then the annual amortisation expense would be ₹10,000 (₹1,00,000 divided by 10 years).
Amortisation involves spreading out the cost of intangible assets over their estimated
lifespan. It is also used to describe the repayment of a loan agreement over a period.
This process typically follows a straight-line method, where the cost is evenly allocated over the asset's useful life. Understanding amortisation is essential for accurately assessing the true cost of borrowing and intangible assets. In the realm of loans, amortisation represents the systematic repayment of debt through periodic instalments, encompassing both principal and interest. This structured approach aids in reducing the outstanding balance on loans such as mortgages or car loans, facilitated by well-defined amortisation plans.
Additionally, amortisation extends to the allocation of capital expenses linked to intangible assets over a predetermined time frame. This practice, crucial for accounting and tax purposes, ensures a systematic method for expensing intangible asset costs over their useful lifespan.
Depreciation applies to tangible assets and can be calculated using various methods, including straight-line, declining balance, and units of production. Each method allocates the cost of the asset differently based on factors such as usage, time, and expected salvage value. For instance, under the straight-line method, the annual depreciation expense is constant, while under the declining balance method, it decreases over time.
Let’s take an example - you purchase a new office building to expand your business and use it for many years. You then decide to relocate to a new office. You use depreciation to calculate the cost of the original building, minus its resale value that is spread out over the life of the building, with a part of the cost being expensed in each accounting year.
Vehicles, on the other hand, are depreciated on an accelerated basis, where a part of the asset’s value is expensed in the early years of the vehicle’s useful life.
Both amortisation and depreciation have tax implications for businesses. The expenses incurred through amortisation and depreciation can be deducted from your company's taxable income, reducing its tax liability. However, tax laws and regulations govern the deductibility of these expenses, and you must comply with specific rules and guidelines set forth by tax authorities.
One common misconception is that amortisation and depreciation are interchangeable terms. While they both involve the allocation of costs over time, they apply to different types of assets and follow distinct accounting principles. Another misconception is that these expenses represent a decline in the asset's market value. In reality, amortisation and depreciation reflect the consumption of the asset's economic benefits over its useful life, rather than a decrease in its market worth.
In summary, amortisation and depreciation are fundamental concepts in accounting used to allocate the cost of assets over their useful lives. While they share similarities, such as spreading out costs over time, they apply to different types of assets and follow distinct methods of calculation.
If you are calculating the depreciation cost of your vehicle, it is important to consider that Royal Sundaram offers a depreciation waiver cover for your asset. This implies when you make a claim, you are eligible for a full return without any deductions on the value of the parts replaced. To know more, check out their website.
