Amortization and depreciation are non-cash expenses on a company's income statement. Depreciation represents the cost of capital assets on the balance sheet being used over time, and amortization is the similar cost of using intangible assets like goodwill over time.
Calculating the proper expense amount for amortization and depreciation on an income statement varies from one specific situation to another, but we can use a simple example to understand the basics.
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The process starts on the balance sheet and ends on the income statement. The accounting of amortization and depreciation is essentially the same, so for our example we can simplify the process and just consider a simple equipment purchase. Remember that an intangible asset would amortize in a very similar way over time, be it intellectual property, goodwill, or another account.
When a company buys a capital asset like a piece of equipment, it reports that asset on its balance sheet at its purchase price. Let's say that our company buys a piece of equipment for $15,000. That means our equipment asset account increases by $15,000 on the balance sheet. Nothing is reported on the income statement, yet.
Over the next year though, the company will begin to recognize a depreciation expense for the equipment, representing its gradual obsolescence, loss of value from use, and increased age. That expense, which appears on the income statement, is not for the full purchase price of the equipment, but rather an incremental amount calculated from accounting formulas.
The first step in this calculation is determining which depreciation method will be used to determine the proper expense amount. The simplest method is the straight line method, where depreciation expense is constant over time as the equipment is used. Other methods allow the company to recognize more depreciation expense earlier in the life of the asset. The key is for the company to have a consistent policy and well defined procedures justifying the method.
For simplicity, we'll use the straight line method in this example. First the company must determine the value of the asset at the end of its useful life. This salvage value, or residual value, is subtracted from the purchase price and then divided by the number of years in the asset's useful life. In the case of our equipment, the company expects a useful life of seven years at which time the equipment will be worth $4,500, its residual value.
Completing the calculation, the purchase price subtract the residual value is $10,500 divided by seven years of useful life gives us an annual depreciation expense of $1,500. This will be the depreciation expense the company recognizes for the equipment every year for the next seven years.
How this calculation appears on the financial statements over time. Each of the next seven years, the company will recognize annual depreciation expense of $1,500 on the income statement. At the same time, the book value of the equipment will reduce on the balance sheet by that same $1,500 per year. The reduction in book value is recorded via an account called accumulated depreciation. The chart below summarizes the seven-year accounting life of this equipment.
Each year, the income statement is hit with a $1,500 depreciation expenses. That expense is offset on the balance sheet by the increase in accumulated depreciation which reduces the equipment's net book value. As the name of the "straight-line" method implies, this process is repeated in the same amounts every year.
One final consideration on depreciation and amortization expensesIn strict terms, amortization and depreciation are non-cash expenses. In the example above, the company does not write a check each year for $1,500. Instead, amortization and depreciation are used to represent the economic cost of obsolescence, wear and tear, and the natural decline in an asset's value over time.
But just because there may not be a real cash expenses for amortization and depreciation each year, these are real expenses that an analyst should pay attention to. For example, if the equipment purchased above is critical to the business, it will have to be replaced eventually for the company to operate. That purchase is a real cash event, even if it only comes once every seven or 10 years.
In many cases it can be appropriate to treat amortization or depreciation as a non-cash event. However, the best analysts will first understand what is being amortized or depreciated, understand how those assets fit into the company's operations, and then make a conscious decision on how to treat these expenses that makes the most sense for that specific situation.
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