Asset depreciates. Measuring the loss in value over time of a fixed asset, such as a building or a piece of equipment or a motor vehicle, is known as depreciation.
Depreciation is considered an expense and is listed in an income statement under expenses. In addition to vehicles that may be used in your business, you can depreciate office furniture, office equipment, any buildings you own, and machinery you use to manufacture products. Land is not considered an expense, nor can it be depreciated. Land does not wear out like vehicles or equipment do. To find the annual depreciation cost for your assets, you need to know the initial cost of the assets.
You also need to determine how many years you think the assets will retain value for your business. The truck loses value the minute you drive it out of the dealership.
The truck is considered an operational asset in running your business. Each year that you own the truck, it loses some value, until the truck finally stops running and has no value to the business. To accurately create your historical financial statements or your pro forma projected financial statements you need to calculate both depreciation and amortization.
Hence if you are creating a business plan you need to calculate both depreciation and amortization. The key is for the company to have a consistent policy and well defined procedures justifying the method. For simplicity, we'll use the straight line method in this example. First the company must determine the value of the asset at the end of its useful life.
This salvage value, or residual value, is subtracted from the purchase price and then divided by the number of years in the asset's useful life. This will be the depreciation expense the company recognizes for the equipment every year for the next seven years. The reduction in book value is recorded via an account called accumulated depreciation. The chart below summarizes the seven-year accounting life of this equipment. That expense is offset on the balance sheet by the increase in accumulated depreciation which reduces the equipment's net book value.
As the name of the "straight-line" method implies, this process is repeated in the same amounts every year. One final consideration on depreciation and amortization expenses In strict terms, amortization and depreciation are non-cash expenses.
Instead, amortization and depreciation are used to represent the economic cost of obsolescence, wear and tear, and the natural decline in an asset's value over time. But just because there may not be a real cash expenses for amortization and depreciation each year, these are real expenses that an analyst should pay attention to. For example, if the equipment purchased above is critical to the business, it will have to be replaced eventually for the company to operate.
That purchase is a real cash event, even if it only comes once every seven or 10 years. In many cases it can be appropriate to treat amortization or depreciation as a non-cash event.
However, the best analysts will first understand what is being amortized or depreciated, understand how those assets fit into the company's operations, and then make a conscious decision on how to treat these expenses that makes the most sense for that specific situation. Need help navigating your way around an income statement? We have the tools to help you get started investing.
Just head on over to our Broker Center. This results in far higher profits than the income statement alone would appear to indicate. Firms like these often trade at high price-to-earnings ratios , price-earnings-growth PEG ratios , and dividend-adjusted PEG ratios , even though they are not overvalued.
The main difference between depreciation and amortization is that depreciation deals with physical property while amortization is for intangible assets. Both are cost-recovery options for businesses that help deduct the costs of operation.
Calculating amortization and depreciation using the straight-line method is the most straightforward. You can calculate these amounts by dividing the initial cost of the asset by the lifetime of it. Accessed Sept. Actively scan device characteristics for identification.
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