Amortization vs Depreciation: What’s the Difference?

amortization accounting

Small businesses that fail to account for amortization risk overvaluing their companies by implying value that isn’t really there. Any false company value can adversely affect your law firm bookkeeping financial statements, which can drive away potential investors or financiers. Save yourself—and your business—the headache and learn to amortize your intangible assets correctly.

Amortization makes it easier for your startup to manage its cash flow and make long-term investments in things like research and development. It also helps you and investors understand and forecast your cash flow and costs over time to manage your finances better. Not all loans are designed in the same way, and much depends on who is receiving the loan, who is extending the loan, and what the loan is for. However, amortized loans are popular with both lenders and recipients because they are designed to be paid off entirely within a certain amount of time. It ensures that the recipient does not become weighed down with debt and the lender is paid back in a timely way.

Paying Off a Loan Over Time

Amortization can help you lower up-front costs and manage your finances more effectively. It’s also a powerful tool when you use it correctly and should be part of any startup’s budgeting process. And when paired with strong financial management, you’re better equipped to forecast your costs accurately and plan for the future. Depreciation is determined by dividing the asset’s initial cost by its useful life, or the amount of time it is reasonable to consider the asset useful before needing to be replaced.

It would be entered into the general ledger as a debit of $12,000 to the current asset account and a credit for the same amount to the cash account. Similarly, the expense will reach the total of the prepaid amount at the end of that same period. Prepaid expenses are also considered a current asset because they can be easily liquidated—the value can be realized or converted to cash in one year or less. Explore the future of accounting over a cup of coffee with our curated collection of white papers and ebooks written to help you consider how you will transform your people, process, and technology.

Amortization of Intangible Assets

Overall, while there are some potential risks with amortization for startups, the advantages may outweigh them, depending on your business’s particular needs. So, for example, the brand value of a company logo or mascot may be amortized, while the resale price of their manufacturing machines may depreciate. Amortization, in general, is writing off a part of its value every year. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments. Residual value is the amount the asset will be worth after you’re done using it.

amortization accounting

There are various types of assets that companies use in daily operations to generate revenues. Among these are fixed assets, which they use in the long run to generate revenues. If you pay $1,000 of the principal every year, $1,000 of the loan has amortized each year. You should record $1,000 each year in your books as an amortization expense. Amortization also refers to the repayment of a loan principal over the loan period. In this case, amortization means dividing the loan amount into payments until it is paid off.

Amortization vs. Depreciation

In accounting, the amortization of intangible assets refers to distributing the cost of an intangible asset over time. You pay installments using a fixed amortization schedule throughout a designated period. And, you record the portions of the cost as amortization expenses in your books.

  • Similar to depreciation, amortization is effectively the “spreading” of the initial cost of acquiring intangible assets over the corresponding useful life of the assets.
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  • We can use an amortization table, or schedule, prepared using Microsoft Excel or other financial software, to show the loan balance for the duration of the loan.
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  • This method is also used by the IRS in calculating any amortization value on Form 4562 (PDF).
  • You must use depreciation to allocate the cost of tangible items over time.