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Amortization vs depreciationAmortization and depreciation are two words that are often used synonymously. Quite often, such interchanging of terms is harmless because both accounting charges are quite alike. However, there are some major differences related to the two, which must be borne in mind. Amortization is writing off of loans or intangible assets in equated annual/monthly installments over a scheduled period. Depreciation is writing off of tangible asset as consumed on pro-rata basis, for estimated pre-defined life of the asset.
Both can be calculated in straight-line and diminishing balance methods:
Both reduce the values of assets in the books to zero. Both are accounting charges. The two can also co-exist. For example, a business buys a car by taking a loan. The loan will be amortized, and the car will be depreciated. Here it would be wrong to say that car is amortized.
Equated installment of an amortization loan has two components, i.e., the interest component and the component of loan that is being repaid. Unlike it, depreciation charge cannot be segregated into two components.
Loans that are being amortized are generally obtained by mortgaging the property, which continues as long as any part of the loan remains outstanding. The same is not true for depreciation. If an asset is acquired by taking a loan, and as a security, this asset is mortgaged, then amortization of loan, and depreciation of asset will go on simultaneously. If, however, the loan is repaid much before the life of asset is exhausted, then, the asset continues to be depreciated, whereas amortization aspect of it ceases.
Another crucial difference is that quantum of loan installments influence purchase decisions. That is, amortization of loans becomes a primary concern due to variables like interest rate, tenure, quantum of loan, etc. If the installment is higher, the borrower may opt to defer or forego the purchase. It is, however, unlikely that a business enterprise will forego its decision to purchase an asset because of higher depreciation charges. If at all, such higher depreciation is likely to result in tax savings.
Depreciation is essentially asset value reduction through an annual accounting charge. Unlike it, amortization reduces both assets and liabilities, i.e., it is applicable to intangible assets, which are assets, and loans, which are are liabilities.
Tax benefits related to amortization differ from those related to depreciation, especially in cases of home loans. The interest component from home loan installments is allowed as expense for purposes of tax. The principal component from these installments, however, does not entitle the borrower to any tax benefits. Unlike it, entire amount of depreciation is expensed for tax purposes.
International Accounting Standard 36 and 38 lay down the principles and rules for accounting amortization. On the other hand, International Accounting Standard 16 and 36 cover depreciation rules. Within United States, Generally Accepted Accounting Principles (GAAP)'s Statement of Accounting Standard No.142 is the one that lays down the method for accounting amortization. In case of depreciation, it is Accounting Standard No.6, which lays down the rules.
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