Depreciation vs Amortization

Depreciation and amortization both spread the cost of a long-lived asset across the years it is used. The difference is what they apply to. Depreciation covers tangible assets such as equipment and buildings. Amortization covers intangible assets such as patents, software, and acquired customer lists. Both are non-cash charges, meaning they reduce reported profit without any cash leaving the business in that period.

Definition and the formula

Both methods most commonly use the straight-line formula Annual Charge = (Cost - Salvage Value) / Useful Life. Depreciation applies it to physical assets that wear out; amortization applies it to intangibles that lose value or expire over a defined period.

Because the cash was spent when the asset was bought, the annual charge is non-cash. On the cash flow statement it is added back to net income, which is why it sits near the top of the indirect method.

Worked example in Excel

A machine costs 1,000 with a 100 salvage value and a five-year life. A patent costs 600 with no salvage and a three-year life. Put the machine cost in B2, salvage in B3, and life in B4.

1. Machine annual depreciation: =(B2-B3)/B4 returns 180.
2. After five years, accumulated depreciation is =5*180, or 900, leaving the 100 salvage as net book value.
3. Patent annual amortization: =600/3 returns 200.
4. Both charges reduce profit but are added back on the cash flow statement as non-cash.

=(1000-100)/5 returns 180, the straight-line depreciation.

Why it matters

Separating depreciation from amortization tells you how much of a firm's non-cash cost comes from physical investment versus acquired intangibles. Heavy amortization often signals a company that has grown through acquisitions, since deals create intangible assets.

Both charges are added back to compute EBITDA, so a business with large non-cash charges can show modest net income yet strong EBITDA and operating cash flow. The schedules also feed deferred tax, since tax depreciation often differs from book.

• Depreciation: tangible assets, the schedule ties to capex.
• Amortization: intangible assets, often from acquisitions.
• Both are added back to reach EBITDA and operating cash.

Nuances and mistakes

Some intangibles, such as goodwill and indefinite-lived brands, are not amortized at all. Instead they are tested for impairment. Treating goodwill like a wasting asset and amortizing it is a common modeling error.

Accelerated methods such as declining balance front-load the charge, which matters for tax and for cash. Do not assume straight-line everywhere; check the policy, since the depreciation pattern changes the timing of profit and tax.