What are Depreciation and Amortization?

• Depreciation is the systematic allocation of a tangible asset’s cost—such as machinery, buildings, or equipment—over its estimated useful life.
• Amortization applies the same principle to intangible assets—like patents, trademarks, or software—aligning their expense recognition with the benefits they deliver.

Why are Depreciation and Amortization Important?

Depreciation and Amortization are crucial because they:

• Match Costs with Revenues: Ensure expenses are recognized in the same periods as the revenues those assets help generate.
• Reflect Asset Consumption: Provide insight into how assets lose value, guiding replacement and maintenance decisions.
• Impact Profitability and Cash Flow: While non-cash, these expenses reduce reported earnings and can offer tax advantages without affecting cash balances.

How are Depreciation and Amortization Calculated?

Common methods include:

• Straight-Line: Spreads cost evenly.

  Annual Expense = (Cost − Salvage Value) ÷ Useful Life
  

• Declining Balance: Accelerates expense in early years.
• Units of Production (Depreciation only): Bases expense on actual asset usage.
• Amortization: Typically straight-line over the intangible’s legal or useful life.

  Annual Amortization = Cost ÷ Useful Life
  

Additional Considerations

• Salvage Value: Estimated residual value impacts the depreciable base.
• Useful Life Reviews: Companies should reassess useful lives and adjust schedules if business conditions change.
• Impairment Testing: Assets must be tested for impairment when indicators suggest their carrying amounts may not be recoverable.