If you want to invest in a publicly traded company, conducting a thorough analysis of its financial data can help you determine the company’s financial performance. There are many different financial terms and concepts included in the income statements. Two of these concepts – depreciation and amortization – can be somewhat confusing, but they are essentially used to calculate the declining value of assets over time. Amortization occurs when the consumption of intangible assets is spread over time, while depreciation happens when fixed assets lose their value over time.
Depreciation Expense and Accumulated Depreciation
Depreciation expense is an item on the income statement. It is recorded when companies acknowledge the loss of value of their fixed assets through depreciation. Physical assets like machinery and equipment or vehicles deteriorate over time and decrease in value gradually. Unlike other expenses, depreciation expenses are listed on the income statements as a “non-cash” expense, indicating that no cash is exchanged when the expenses occur.
Accumulated depreciation is recorded on the financial statement. This item reflects the total depreciation expenses accumulated so far on a specific asset as its value declines due to wear and tear.
When depreciation expenses appear on the income statement, instead of reducing cash on the financial statement, they are added to the accumulated depreciation account. This results in a decrease in the carrying value of the related fixed assets.
Example: Depreciation Expense
Over the past decade, Sherry’s Cotton Candy Company has reported an annual profit of $10,000. In one year, the company purchased a cotton candy machine for $7,500, which is expected to last for five years. An investor examining the cash flow might be disappointed to see that the company reported only $2,500 (profit of $10,000 minus equipment expense of $7,500).
In response, Sherry’s accountants explain that the expense of the machine valued at $7,500 must be allocated over the five-year period during which the machine is expected to benefit the company. The cost each year will be $1,500 ($7,500 divided by five years).
Instead of incurring one large expense for that year, the company deducts depreciation of $1,500 each year for the next five years and reports annual profits of $8,500 (profit of $10,000 minus $1,500). This calculation provides investors with a more accurate representation of the company’s ability to generate profits.
However, this method also faces an issue. Although the company reported profits of $8,500, it still wrote a check for $7,500 for the machine and only has $2,500 in the bank at the end of the year. If the machine does not generate any revenue in the following year, and the company’s profits remain the same, then a depreciation amount of $1,500 will be recorded on the income statement under depreciation expenses, reducing the net income to $7,000 (profits of $8,500 minus $1,500 depreciation).
Example: Amortization
In a very eventful year, Sherry’s Cotton Candy Company acquired Millie’s Muffins, a bakery known for its delicious treats. After the acquisition, the company added the value of the baking equipment and other tangible assets to its balance sheet.
It also added the value of Millie’s brand, an intangible asset, as an item on the balance sheet labeled recognized value. Since the IRS allows a 15-year period for the use of recognized value, Sherry’s accountants show 1/15 of the recognized value from the acquisition as an amortization expense on the income statement each year until the asset is fully amortized.
Limitations
Accounting and Real Profit
Some investors and analysts believe that depreciation expenses should be added to a company’s earnings because they do not require any immediate cash payments. These analysts suggest that Shiri did not actually pay $1,500 annually. They argue that the company should add the depreciation figures to the reported earnings of $8,500 and assess the company based on the figure of $10,000.
Depreciation is a very real expense. In theory, depreciation attempts to match profit with the expense incurred to achieve that profit. An investor who ignores the economic reality of depreciation expenses can easily overestimate the value of the business and may risk their investment as a result.
Final Thoughts
Value investors and asset management companies sometimes buy assets that require significant initial fixed expenses, leading to huge depreciation expenses for assets that may not need replacing for decades. This results in earnings that appear much higher than those reflected on the income statement alone. Such companies typically trade at high price-to-earnings ratios, price-to-growth ratios, and adjusted earnings price-to-earnings ratios, even though they are not excessively overvalued.
Frequently Asked Questions (FAQs)
What is the difference between depreciation and amortization?
The main difference between depreciation and amortization is that depreciation deals with tangible assets while amortization deals with intangible assets. Both are options for cost recovery for companies that help in deducting operating costs.
How to calculate depreciation and amortization?
The simplest way to calculate depreciation and amortization is using the straight-line method. You can calculate these amounts by dividing the asset’s initial cost by its useful life.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
IRS. “Publication 535, Business Expenses”, pages 31-32.
Source: https://www.thebalancemoney.com/depreciation-and-amortization-on-the-income-statement-357570
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