What are Depreciation and Amortization?

• Depreciation refers to the systematic allocation of the cost of a tangible asset (e.g., machinery, buildings, equipment) over its estimated useful life.
• Amortization is the similar allocation for intangible assets (e.g., patents, trademarks, software).

Together, they spread out the expense of long-lived assets on the income statement, matching cost with the revenue those assets generate.

Why are Depreciation and Amortization Important?

Depreciation and Amortization are important because they:

• Reflect the consumption and aging of assets, providing a more accurate picture of asset value and profitability.
• Ensure compliance with accounting principles by matching expenses with related revenues in each period.
• Reduce taxable income without affecting cash flow, since they are non-cash expenses.

How are Depreciation and Amortization Calculated?

Common methods include:

• Straight-Line Method: Spreads cost evenly over the asset’s useful life.

  Annual Depreciation Expense = (Cost of Asset - Salvage Value) ÷ Useful Life
  

• Declining Balance Method: Accelerates expense recognition in earlier years.

• Units of Production (Depreciation only): Bases expense on asset usage.

• Amortization for Intangibles: Usually straight-line over the asset’s legal or useful life.

  Annual Amortization Expense = Cost of Intangible Asset ÷ Useful Life
  

Additional Considerations

• Salvage Value: The estimated residual value of an asset at the end of its useful life impacts depreciation calculations.
• Review of Useful Lives: Companies should periodically reassess asset useful lives and adjust depreciation schedules if necessary.
• Impairment: When asset value falls below its carrying amount, an impairment loss is recognized, affecting both depreciation schedules and financial results.