Depreciation and amortization both function to account for changes in the value of assets owned by a business. However, they relate to different types of assets and don't affect each other. Both expenses become part of the calculation of the business' overall income, with higher expenses resulting in lower incomes.
To operate, a business needs to have various assets. For depreciation and amortization purposes, these assets fall into two categories: tangible and intangible. Tangible assets or hard assets refer to real and personal properties, such as real estate, machinery, equipment and office furniture. On the other hand, intangible assets include financial investments, intellectual property and licenses. Both types of assets generate value for the business and last for more than one year. As such, you need to account for these assets over their useful life.
You can amortize the costs of starting a business, getting a lease and intangibles. You must first determine the length of life of an intangible asset. For example, if you spend $5,000 to set up a partnership and expect the partnership to last for three years, then you have to amortize the costs over three years. To do so, divide the costs equally for each year so you amortize $1,666.67 every year for the three years.
You can use several different methods to depreciate tangible assets. The most common way is straight-line depreciation, which is the same method you use for amortization. Straight-line depreciation involves dividing the costs equally over the number of years you expect to use the asset. You may also choose accelerated depreciation, whereby you claim a bigger depreciation expense in the first few years and a smaller depreciation expense later. Another way is to match the amount of depreciation with the amount of use.
Both amortization and depreciation involves an upfront payment at the beginning of the asset's useful life. However, you can't account for the expense immediately because the asset remains useful for more than one tax year. As such, you estimate the length of the useful life and allocate the expenses you deduct from your taxes each year. Amortization and depreciation, therefore, reduce reported income and tax liability without always affecting cash flow. Depreciation always provides tax benefits, while amortization does not generate tax benefits in the case of some intangible assets, such as goodwill. While they share many features, depreciation and amortization don't affect each other because they relate to different asset types.
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