Amortisation vs Depreciation: One Rule, Two Kinds of Asset

Depreciation writes down something with physical substance and amortisation writes down something without it. Beyond the kind of asset, the arithmetic is largely the same: a cost, a life, a pattern, a charge each year. The distinction is worth knowing because intangibles carry harder judgements, some are never amortised at all, and the word amortisation means something entirely different when a lender uses it.

Underneath sits a single problem shared by both words. One payment buys several years of usefulness, and the accounts must apportion it across them rather than dump it where the invoice fell. Matching is the answer to that problem. Matching does not care whether the thing is made of steel or of code. A binding machine and a stock-control software module are both long-lived, both paid for once, and both used across several years, so both get spread. Two different words attach to the same spreading rule purely because the assets sit in two different places on the balance sheet.

Three things are already settled: a charge is cost divided across a useful life, three judgements sit inside every such figure, and the cash left when the asset was bought, so the charge never moves cash. Still open are the second word, why it exists, and the two places where the pair stops behaving symmetrically: one class of asset gets neither charge, and the word amortisation means something else again when a lender says a loan amortises over seven years.

What does depreciation mean on its own?

The contrast is worth nothing until each side is solid on its own, so the two terms come one at a time. Depreciation, the familiar one, comes first.

Depreciation is the systematic charging of the cost of a tangible assetSomething the business holds that has physical substance: machinery, buildings, vehicles, fittings, computers. A tangible asset can be walked up to and touched. against the years that use it. Physical substance is the whole qualifying test. A machine, a shed fitting, a delivery van, a computer: each one can be found on the premises and touched. A machine wears out, breaks, becomes slower than what the market now sells, and one day the business stops using it. The useful life is an estimate of how long this particular business expects to keep using it, not how long the object could physically survive in ideal conditions.

Depreciation spreads a payment already made across the years of use of something with physical substance, and the physical substance is the only part of that sentence that separates it from the other term. Anjani Stationers Private Limited, an invented stationery business, runs the case. Its second binding machine cost Rs 9,00,000 and the business expects to use it for six years with nothing assumed to be left at the end. Rs 9,00,000 divided by six is Rs 1,50,000, and that Rs 1,50,000 is charged in each of the six years. The carrying amountWhat an asset is shown at on the balance sheet right now: its cost less everything charged against it so far. The carrying amount is a running remainder, not a market price. falls in six equal steps from Rs 9,00,000 to nil.

What does amortisation mean on its own?

Now the second term. AmortisationThe systematic charging of the cost of an asset with no physical substance against the years expected to benefit from it, over a life the business estimates. is the systematic charging of the cost of an intangible assetSomething the business holds that has value but no physical substance: purchased software, a licence, a patent, a customer list bought as part of an acquisition. that has a finite life against the years expected to benefit from it. An intangible asset is something the business holds that has no physical form. Purchased software, a licence to use a process, a patent bought from somebody else, a customer list acquired along with a business: none of these can be picked up, and each of them can still be worth real money.

Think about a household for a moment. A second-hand car and a five-year membership of a sports club both cost money once and are both used for years. Nobody would find it strange to say the car is being used up. The membership is being used up in exactly the same way, at exactly the same steady rate, and the only reason it feels different is that there is nothing in the driveway to look at. Amortisation is the same spreading rule applied to the assets that cannot be looked at, and the absence of something to look at is the source of every extra difficulty the term carries.

Anjani Stationers runs one intangible, software. In year two the business bought a stock-control module for Rs 1,00,000 and expects the benefit to last four years. The annual charge is Rs 1,00,000 divided by four, Rs 25,000. The older software already sitting in the block carries a combined charge of Rs 75,000 for the year, so the total amortisation for year two is Rs 1,00,000. The Rs 1,00,000 total closes the software ladder: opening gross Rs 7,00,000 less accumulated amortisation Rs 3,00,000 gave a net of Rs 4,00,000, the Rs 1,00,000 addition takes gross to Rs 8,00,000, the Rs 1,00,000 charge takes accumulated to Rs 4,00,000, and the net stays at exactly Rs 4,00,000. The addition and the charge happen to be the same size, so the published software figure did not move all year. The equal size is a coincidence of this particular year and not a rule.

Is the arithmetic actually any different?

Put the two calculations side by side and look for the difference.

Rs 9,00,000 divided by six is Rs 1,50,000. Rs 1,00,000 divided by four is Rs 25,000. The two divisions are the same operation performed twice. Both begin with a cost the business actually paid and can show an invoice for. Both divide it across an estimated useful life. Both can be charged evenly or in a front-loaded pattern. Both reduce the carrying amount on the balance sheet by exactly what they charge. Both land above the operating profit line and cut it in full. In both cases the money left when the asset was bought, so both are non-cash. The arithmetic is not different in any respect, and no formula separates the two.

The difference is the evidence available for the one estimate that matters most. Asking how long a binding machine will be used sends the analyst out to the floor, to look at the machine, ask the operator how often it jams, check what the supplier says about servicing, and look at what happened to the last one. Asking how long a stock-control module will be used leads nowhere physical. The estimate is of how long a way of working will remain the way of working, and the honest answer is frequently that nobody knows. There is nothing physical to look at when the estimate is made and nothing physical to look at when somebody later asks whether it was right, so the harder question in amortisation is almost always the life.

Why does an indefinite-life intangible get neither charge?

Here is where the pair stops being symmetrical, and it is the one asymmetry a reader has to hold on to. Depreciation always ends. Physical things do not last forever, so every tangible asset has a life somebody can put a number on, even if the number is a rough one. Amortisation does not always start.

Some intangibles have an indefinite useful lifeA life for which no foreseeable limit can be identified, so no sensible number of years can be put on the benefit. An indefinite life is a conclusion the business reaches and must revisit, not a permanent label.. If a business cannot identify any foreseeable limit to the period over which the asset is expected to produce benefits, there is no denominator to divide by, and dividing a cost by an unknown number of years produces an answer nobody can defend. So the charge is not made at all. Instead the asset is subjected to an impairment testA check comparing what an asset is carried at against what it could realistically deliver, either by being sold or by being kept and used. A shortfall is written off at once. every year, and if the carrying amount is no longer supportable it is written down in one step rather than in slices.

Indefinite does not mean infinite, and confusing the two is the single most common error on this subject. Indefinite means no foreseeable limit can be identified today, from where the business is standing, on the evidence it has. Indefinite is a conclusion, and conclusions are revisited. A business that reaches it in one year and finds a limit in the next starts amortising from that point. Nobody has claimed the asset is permanent. The business has said it cannot yet see the end of it.

The case a reader will meet most often is goodwillThe amount by which what an acquirer paid for a business exceeds the fair value of the identifiable assets and liabilities it acquired. Goodwill arises only on a purchase and can never be created internally.. Anjani Stationers paid Rs 21,00,000 for a 70 per cent holding in Chitra Binding Works Private Limited, and the consolidated accounts carry goodwill of Rs 3,50,000 arising on that purchase. The Rs 3,50,000 of goodwill sits outside the whole spreading system. Goodwill carries no annual charge, appears nowhere in the Rs 12,00,000 of depreciation and amortisation, and is tested every year instead. Note where the goodwill lives, too. The Rs 3,50,000 appears on consolidation. The standalone balance sheet carries the Rs 21,00,000 investment in Chitra Binding and no goodwill at all.

Why do depreciation and amortisation share one reported line?

So why does a reader almost never see the two charges apart?

Because presentation fuses them. Indian filings show depreciation and amortisation together as a single expense line, and Anjani Stationers' year two figure of Rs 12,00,000 is exactly that fusion: Rs 11,00,000 of depreciation across the existing block, the year two additions and the leased warehouse, plus Rs 1,00,000 of amortisation across the older software and the new module. On the face of the statement of profit and loss there is one number. The face does not carry the split, so a reader who wants to know how much of that Rs 12,00,000 will require real money again has to leave the face of the statement and go to the notes.

The fusion matters more than a presentation quirk should, and the reason is earnings before interest, tax, depreciation and amortisation (EBITDA). EBITDA adds back the whole line. EBITDA does not add back Rs 11,00,000 of depreciation and Rs 1,00,000 of amortisation as two separate acts of judgement. It takes the fused Rs 12,00,000 and puts it back. So a business whose charge is almost entirely machinery and a business whose charge is almost entirely acquired intangibles arrive at the EBITDA line looking identical, and they arrive at the earnings before interest and tax (EBIT) line looking identical too, and everything that separates them has been added back and thrown away in a single step.

Does the word amortisation mean something else when a lender uses it?

The word does, and the two senses are confused more often than anything else on the subject. In a bank, discussing a loan, somebody will say the facility amortises over seven years. Nothing in that sentence has anything to do with writing down an asset.

In lending, amortisation means the repayment of principal across the term of a debt. An amortising loanA loan whose instalments repay the borrowed principal gradually across the term, so the outstanding balance falls to nothing by the end rather than sitting there until a single final repayment. is one whose instalments chip away at the amount borrowed, so the outstanding balance falls year by year and reaches nil at the end. The opposite arrangement, where the instalments cover only interest and the whole principal is repaid in one payment at the end, is not amortising. Every household with a home loan lives inside this meaning: each month's instalment is part interest and part principal, and the principal part is the amortisation.

The two senses point in opposite directions. Look at what each is actually doing. The accounting sense writes an asset down and moves no cash; the lending sense pays a liability off and moves cash every single instalment. One reduces something the business holds. The other reduces something the business owes. One is a charge in the statement of profit and loss. The other is a movement in the financing section of the cash flow statement, with only its interest portion touching profit at all. The two senses share a word, they share the Latin root of gradually killing something off, and they share nothing else.

Anjani Stationers happens to carry both senses inside one arrangement, the cleanest possible demonstration. The warehouse taken on a four-year lease produced a right-of-use asset of Rs 7,00,000 and a lease liability of Rs 7,00,000, one on each side. Over year two the asset was depreciated by Rs 1,75,000, so it is carried at Rs 5,25,000. Over the same year the payments made reduced the liability to the published Rs 6,00,000, of which Rs 2,00,000 falls due within the next year and Rs 4,00,000 after it. One of them was written down by a charge and the other was paid down with money, so two figures that started identical are now Rs 75,000 apart.

How does Anjani Stationers' Rs 12,00,000 split into its parts?

Bring both terms back together on one set of accounts and work the whole thing to the rupee. The face of the statement carries only the last row of the table below. The rest is what a reader reconstructs from the notes.

Read the last row again. It is the one that surprises people. Anjani Stationers carries Rs 3,50,000 of goodwill in its consolidated accounts and charges nothing against it in any year. The point is not that the charge is small. There is no charge. The goodwill will sit at Rs 3,50,000 for as long as the annual test supports it, and the day the test does not support it, the whole shortfall lands at once rather than in slices. An asset carrying no annual charge is not an asset carrying no risk; it is an asset whose entire risk has been moved from the income statement into a single test performed once a year.

Two assumptions hold this table together and both are stated here. Nothing is assumed to be left at the end of any life, so the whole cost of each item is spread. And each of the two year two arrivals was in service from day one of the year. Neither is scaled down to a part year. Change either assumption and every figure in the depreciation section moves.

Three readings carry the whole result. At the published split of Rs 11,00,000 and Rs 1,00,000, EBITDA is Rs 53,50,000, EBIT is Rs 41,50,000 and the illustrative cash needed later is Rs 11,00,000, leaving Rs 25,30,000 of the Rs 36,30,000 of operating cash flow for the year. Drag the whole charge to depreciation and EBITDA is Rs 53,50,000, EBIT is Rs 41,50,000 and the cash needed later is Rs 12,00,000, leaving Rs 24,30,000. Drag it the other way to nothing but amortisation and EBITDA is Rs 53,50,000, EBIT is Rs 41,50,000 and the cash needed later is nil, leaving the whole Rs 36,30,000. Two profit lines that do not flicker across a Rs 12,00,000 swing in what the business will have to spend later is the strongest single argument for reading the notes. Close the notes and the panel can no longer show which of the two worlds is in view. A reader working from the face of the statement alone is in exactly that position.

Who reads the split, and what do they do with it?

The mechanism aside, the two figures reach three readers in a single week and not one of them is looking for a definition.

A lender adds both charges back and then asks which half will come back as a cash demand, an analyst refuses to compare two EBITDA figures until the split is in front of both, and Vaidehi Rao reads it to know what she has to budget for. Watch the lender first. The mechanical move is familiar: Rs 38,00,000 of profit before tax with Rs 12,00,000 of charges restored gives a figure much nearer to what debt can be paid out of. The second move is where the split earns its keep. Rs 11,00,000 of that add-back is machinery, fittings, vehicles, computers and a leased warehouse, and worn-out machinery eventually demands real money before it can be replaced. Rs 1,00,000 of it is software, and software will need replacing too but on a very different scale. The lender is not adding the charge back and forgetting it; the lender is adding it back and then asking how much of it is a bill in disguise.

The analyst's use is comparison, and it starts with a refusal. Putting two notebook makers on the same EBITDA multiple implicitly claims that their add-backs are the same kind of thing. If one carries Rs 11,00,000 of machinery depreciation and the other carries Rs 11,00,000 of amortisation on a customer list bought three years ago, the two businesses face very different futures and the multiple has been applied as though they do not. The analyst therefore reads the property, plant and equipment note and the intangible assets note before the multiple, not after it. And Vaidehi Rao, as finance controller inside the business, has the most direct use of all. She knows the Rs 2,25,000 charged on year two's additions corresponds to machines that will genuinely wear out, that the Rs 1,75,000 on the warehouse tracks a lease term she has already committed to, and that the Rs 25,000 on the stock-control module is a small item with a large question mark over whether four years is right.

One boundary belongs here rather than in a footnote. The split identifies what kind of asset produced the charge; it never establishes that the depreciation will require cash and the amortisation will not. Software gets replaced. Licences get renewed. Machines sometimes get run for years past the end of their assumed life and cost nothing. The split narrows the question usefully and settles nothing, and a reader who converts it into a rule about future cash has taken a classification somewhere it cannot go.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited and Vaidehi Rao are invented.
Educational material. Not advice on any investment, tax, budget or market position.