What Do Depreciation Expense and Amortization Expense Represent in Accounting

Depreciation expense and amortization expense are two accounting concepts that help businesses accurately reflect their financial situation.

Depreciation expense represents the decrease in value of tangible assets, such as equipment and buildings, over their useful life.

The goal of depreciation expense is to match the cost of using up these assets with the revenue earned from their use.

Amortization expense, on the other hand, represents the decrease in value of intangible assets, such as patents and copyrights, over their useful life.

Amortization expense helps businesses recognize the costs of acquiring and using these intangible assets over time.

Depreciation expense is a non-cash expense that allocates the purchase of fixed assets over its estimated useful life. This expense reduces the carrying value of a fixed asset recorded on a company's balance sheet.

Depreciation is used to better match the expense of a long-term asset to periods it offers benefits or to the revenue it generates. Companies use different methods to calculate depreciation, such as accelerated depreciation for assets that depreciate quickly.

The depreciation expense is recognized as an operating cost on the income statement, reducing taxable income and net income. This expense is treated as a non-cash add-back on the cash flow statement since no real outflow of cash has occurred.

Depreciation expense is not typically reported as a separate expense on the income statement, so companies often report it in the footnotes section or on the cash flow statement. This is because depreciation is a non-cash item that doesn't affect a company's cash position.

There are several types of depreciation methods that businesses can use to calculate depreciation expense. The straight-line method is the most common, and it takes an equal depreciation expense each year over the useful life of the asset.

The straight-line method is calculated using the formula (Fair Value – Residual Value) / Useful life of Asset. For example, Company A purchases a building for $50,000,000, to be used over 25 years, with no residual value. The annual depreciation expense is $2,000,000.

Other methods include the declining balance method, which accelerates depreciation, and the sum-of-the-years'-digits method, which also accelerates depreciation. The declining balance method uses a factor higher than one, such as 1.5 or 2, to calculate the depreciation expense. In contrast, the sum-of-the-years'-digits method calculates a percentage of the remaining life of the asset and applies it to the cost less salvage value.

Here are the different types of depreciation methods:

The straight-line method of depreciation is the most common and widely used method. It's the simplest way to calculate depreciation expense, as it equally distributes the expense over the life of the asset.

To calculate straight-line depreciation, you need three inputs: the cost of the asset, the salvage value, and the useful life of the asset. The formula is (cost – salvage value) / useful life.

The straight-line method is preferred by most companies because it results in lower depreciation in the earlier years of the asset's useful life. This means higher net income and earnings per share (EPS) in the initial years.

Here are the three inputs required to calculate straight-line depreciation:

The straight-line method is often used in conjunction with a salvage value assumption, where the remaining value of the asset becomes zero by the end of its useful life. This assumption results in higher depreciation expense each year.

The annual depreciation expense is calculated by dividing the depreciable base (cost – salvage value) by the useful life of the asset. For example, if the depreciable base is $70,000 and the useful life is 10 years, the annual depreciation expense is $7,000.

Here's a summary of the straight-line depreciation method:

The sum-of-the-years'-digits method is an accelerated depreciation approach that recognizes higher depreciation expense in the earlier years of an asset's life. This method is calculated by adding up the years in the useful life and using that sum to calculate a percentage of the remaining life of the asset.

The formula to calculate depreciation expense using this method is Periodic Depreciation Expense = (Cost - Salvage Value) * (Remaining Life / Sum of Years' Digits). For example, if an asset has a useful life of 5 years, summing the digits of the five years of the asset's useful life looks like this: 1 + 2 + 3 + 4 + 5 = 15.

The annual depreciation expense for the first year would be one third (⅓ = 5 /15) of the asset's value, and in year two, the annual depreciation expense percentage would be approximately 27% or 4/15. This method is commonly used by companies with assets that lose their value or become obsolete more quickly.

Here's a breakdown of how the sum-of-the-years'-digits method works:

The units of production depreciation method is a unique approach to tracking the value of assets over time. This method focuses on the actual usage of the asset, rather than the passage of time.

The units of production method is most commonly used for assets that wear out due to actual usage, such as production machinery. It's a more accurate method, but it requires a granular analysis and per-unit tracking, making it the most tedious of the three methods.

To calculate the depreciation expense per unit produced, you divide the historical value of the asset minus the residual value by its useful life in terms of units. This method records a higher expense amount when production is high to match the equipment's higher usage.

The formula for unit depreciation expense is (Fair Value – Residual Value) / Useful Life in Units. For example, if a machine worth $100,000 has a residual value of $5,000 and a useful life of 95,000 units, the unit depreciation expense would be $1.

Here's a simple example to illustrate this: if a company produces 10,000 units in a year, the periodic depreciation expense would be $10,000.

This method is often used in mining operations, where the value of the asset is closely tied to the actual production of units.

Calculating depreciation expense is a straightforward process that involves determining the annual depreciation expense for a fixed asset. The most common method used is the straight-line method, which equally distributes the depreciation expense over the life of the asset.

To calculate straight-line depreciation expense, you need to know the cost of the asset, its salvage value, and its useful life. The formula is (cost - salvage value) / useful life.

For example, a company purchases equipment for $100,000 with a salvage value of $30,000 and a useful life of 10 years. The annual depreciation expense would be $7,000, calculated as ($100,000 - $30,000) / 10 years.

The straight-line method is the simplest method to calculate depreciation expense, but other methods, such as the declining balance method and the units of production method, can also be used.

Here are the three most common methods to calculate depreciation expense:

The straight-line method is the most widely used, as it is easy to calculate and provides a consistent depreciation expense each year. The declining balance method, on the other hand, accelerates the depreciation expense in the early years of the asset's life, while the units of production method calculates depreciation based on the number of units produced.

In practice, the choice of method depends on the type of asset and the company's accounting policies. The straight-line method is often used for assets with a long useful life, while the declining balance method is used for assets with a shorter useful life.

Here's a summary of the key factors to consider when calculating depreciation expense:

By understanding these factors and using the correct method, you can accurately calculate depreciation expense and ensure that your financial statements are accurate and compliant with accounting standards.

Depreciation expense is a reduction in the value of a fixed asset over time due to wear and tear. This is mandatory under US GAAP and is recognized on the income statement in the period the asset is generating revenue.

There are four methods of calculating depreciation: straight-line, declining balance, sum-of-the-years' digits, and units of production. These methods are used to allocate the cost of a fixed asset over its useful life.

The straight-line method of depreciation allocates the cost of a fixed asset evenly over its useful life. For example, if a company purchases equipment for $70,000 and estimates it will last for 10 years, the annual depreciation expense would be $7,000.

The core objective of the matching principle in accrual accounting is to recognize expenses in the same period as when the coinciding economic benefit was received. This is achieved by capitalizing the purchase of fixed assets, such as equipment, and recognizing the depreciation expense over the asset's useful life.

The journal entry for annual depreciation expense is a debit to depreciation expense and a credit to accumulated depreciation. This entry is recorded each year until the end of the asset's useful life, at which point the net fixed asset balance will equal its estimated salvage value.

Here are the four methods of calculating depreciation:

Depreciation expense impacts financial statements in a way that might seem counterintuitive at first. It's a non-cash expense that reduces net income, but it also has a positive effect on the ending cash balance.

Depreciation expense is added back to net income on the cash flow statement because it's a non-cash transaction. This means that even though depreciation expense reduces net income, it doesn't actually reduce the cash balance.

The impact of depreciation expense on the balance sheet is relatively straightforward. It reduces the value of an asset, in this case, property, plant, and equipment (PP&E), by the amount of the depreciation expense.

Here's a summary of the impact of depreciation expense on financial statements:

Overall, depreciation expense is an important consideration when evaluating a company's financial performance, as it can have a significant impact on net income and the cash balance.

Forecasting depreciation can be a straightforward process if you know where to start. You can forecast capital expenditures as a percentage of revenue using historical data as a reference point.

To do this, you'll want to look at the company's past revenue growth and use that as a guide for forecasting future capital expenditures. Management guidance and industry averages should also be referenced to ensure accuracy.

Capital expenditures can be broken down into two categories: growth capex and maintenance capex. Growth capex is optional expenditures to fund growth and expansion plans, while maintenance capex refers to routine spending required for operations to continue.

High-growth companies tend to spend heavily on growth capex, which results in depreciation-capex ratios that far exceed 100%. On the other hand, low-growth companies will have a smaller percentage of revenue allocated to capex, with most of it being maintenance capex.

Here's a rough estimate of how depreciation-capex ratios can vary depending on growth rates:

Understanding these concepts will help you create a more accurate forecast for depreciation. By considering historical trends, management guidance, and industry averages, you can make informed decisions about your company's financial future.

Let's dive into some examples and illustrations to make depreciation expense and amortization expense more concrete.

A manufacturing company purchases $100k of PP&E with a useful life estimation of 5 years, resulting in a $20k annual depreciation expense.

The company pays for the PP&E in all cash, which means $100k in cash is now out the door, but the income statement will show a $20k depreciation expense each year for 5 years.

The straight-line method of depreciation is used to calculate the annual depreciation, which is the remaining book value of the fixed asset divided by the useful life assumption.

Here's a breakdown of the annual depreciation for the first 5 years:

The accumulated depreciation is $100k, which is the total depreciation expense for the 5-year period.

The company has a revenue growth rate that decreases by 1.0% each year until reaching 3.0% in 2025, with revenue figures of $10.0 million in 2021, $10.6 million in 2022, and so on.

The useful life of equipment can be 10 years, and the straight-line method of depreciation is used to calculate the annual depreciation, which is the remaining book value of the fixed asset divided by the useful life assumption.