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. $$\textsf{Annual Expense} = (\textsf{Cost} - \textsf{Salvage Value}) \div \textsf{Useful Life}$$
• 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. $$\textsf{Annual Amortization} = \textsf{Cost} \div \textsf{Useful Life}$$

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.