When it comes to accounting for computer software, there is often confusion about whether it should be amortized or depreciated. Both methods are used to allocate the cost of an asset over its useful life, but they are not interchangeable. In this article, we will explore the difference between amortization and depreciation and determine which method is appropriate for computer software.
Depreciation vs. Amortization
Depreciation and amortization are both methods of allocating the cost of an asset over time. The main difference between them is the type of asset being allocated. Depreciation is used for tangible assets such as buildings, machinery, and vehicles, while amortization is used for intangible assets such as patents, copyrights, and software.
Depreciation is a non-cash expense that reflects the decline in value of a tangible asset over its useful life. The most common method of depreciation is straight-line depreciation. This method allocates an equal amount of the asset’s cost to each year of its useful life.
For example, if a company purchases a building for $500,000 with an estimated useful life of 25 years, it would depreciate the building at a rate of $20,000 per year ($500,000 / 25 years). This means that each year’s income statement would show a depreciation expense of $20,000.
- Straight-line depreciation: allocates an equal amount of the asset’s cost to each year of its useful life.
- Accelerated depreciation: allows more depreciation expense in earlier years than later years.
- Units-of-production: allocates the total cost based on actual usage rather than time.
Amortization works similarly to depreciation but applies to intangible assets instead. It reflects the decline in value of an intangible asset over its useful life.
The most common method of amortization is straight-line amortization.
For example, if a company purchases a patent for $50,000 with an estimated useful life of 10 years, it would amortize the patent at a rate of $5,000 per year ($50,000 / 10 years). This means that each year’s income statement would show an amortization expense of $5,000.
- Straight-line amortization: allocates an equal amount of the asset’s cost to each year of its useful life.
- Accelerated amortization: allows more amortization expense in earlier years than later years.
Is Computer Software Amortized or Depreciated?
Now that we understand the difference between depreciation and amortization let’s determine which method is appropriate for computer software. According to Generally Accepted Accounting Principles (GAAP), computer software should be treated as an intangible asset and therefore should be amortized.
There are a few exceptions to this rule. If the software is considered part of a larger tangible asset such as a computer or server, it can be depreciated along with that asset. Additionally, if the company develops its own software rather than purchasing it from a third-party vendor, it may be eligible for research and development (R&D) tax credits which can offset the cost.
In summary, computer software should be treated as an intangible asset and therefore should be amortized. While there are exceptions to this rule, companies should follow GAAP guidelines when accounting for their assets. By properly allocating the cost of computer software over its useful life, companies can accurately reflect their financial performance and make informed business decisions.