An Introduction to Depreciation and Amortization

Depreciation and amortization are both methods for spreading out the cost of an asset over its lifetime. They are used in accrual accounting, which measures the financial performance of a company based on economic events without taking into account exactly when they occur. An understanding of accrual accounting is necessary before understanding why depreciation and amortization must be taken into account. 

Accounting Standards

The accounting principles used by any company are essential to measuring the company's performance. Without accounting principles, companies could use whichever formulas and methods they would like to inflate their own positions. Thankfully, the emergence of Generally Accepted Accounting Principles (GAAP) keeps companies honest by using a consistent method for all financial reports. As an investor, you can be certain a company is sharing full information on its financial position before releasing the information to shareholders and the public.

Accrual Accounting

One principle used in GAAP is accrual accounting. Essentially, this allows a company to factor in costs for purchasing an asset over the lifetime of the asset instead of all at once. Accrual accounting is used to determine a company's tax liability as well as its financial standing. Imagine this personal example: When you purchase a home for $300,000, you factor in the cost of that purchase over the entire lifetime of a mortgage. You would never record a financial statement showing you spent $300,000 in one year even though you earned only $80,000. Instead, you would consider the cost you spent on your mortgage in a given year. For tax purposes, the interest on your mortgage for only this year would be deducted from your taxes, not the entire interest of the $260,000 mortgage loan you attained. This is essentially accrual accounting.

Depreciation 

One principle in accrual accounting is depreciation. This comes into effect with an asset that will lose value over time. For example, a landscaping company purchased a new tractor this year. The tractor cost $120,000, and each year it will lose a portion of its value until it must be sold off and replaced. The lifetime of the tractor is expected to be 15 years. Instead of counting the entire $120,000 as an expense this year, then, the company will count only $8,000, or one year's worth of the expense, this year. As an investor, you will get a clearer picture of the company's spending. You will know the investment can be carried over many years and is not simply a one-time cash expense. 

Amortization

Amortization is often harder for a casual investor to understand because there are few personal examples. Amortization weighs the initial cost to attain an asset over the lifetime in which it will generate a profit. A common example involves developing a pharmaceutical drug. The first year's expense could be in the many millions of dollars. The first year's profit, though, may be only a few million. Thankfully, the patent on the pharmaceutical lasts 17 years. This means the expected profits over the lifetime of the drug can be factored in. The cost of developing the drug is amortized over the 17-year lifespan of profits. 

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