10 October 2017
Depreciation
Depreciation is a term used for tax andaccounting purposes that describes the method a company uses to account for the declining value of its assets.
HOW IT WORKS (EXAMPLE):
An asset acquired in 2005 is unlikely to be worth the same amount five years later; most of the time, the asset will have worn down, been depleted, or become obsolete.
While there are many ways to calculate depreciation, the most basic is the "straight line" method. Under this method, the depreciation of a given asset is evenly divided over its useful lifetime. The method entails dividing the cost of the asset (minus its salvage value) by its estimated useful life.
For example, let's say Company XYZ bought a machine that helps them produce widgets. The machine cost $30,000 and is expected to last 10 years. It's "salvage value" (the amount the machine is worth after 10 years of use) is $3,000. In this particular case, Company XYZ would take a non-cash charge of $2,700 peryear to account for the asset's annual depreciation [($30,000 - 3,000) / 10 = $2,700].
Amortization
Amortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a period of time. It also refers to the repayment of loan principalover time.
HOW IT WORKS (EXAMPLE):
Let's assume Company XYZ owns the patenton a piece of technology, and that patent lasts 15 years. If the company spent $15 million to develop the technology, then it would record $1 million each year for 15 years as amortization expense on its income statement.
Alternatively, let's assume Company XYZ has a $10 million loan outstanding. If Company XYZ repays $500,000 of that principal every year, we would say that $500,000 of the loan has amortized each year.
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