A simple way of explaining depreciation and amortization is through an example of automobile ownership. Depreciation is the practise of expensing the cost of an asset over its useful life and is obtained by subtracting the liquidation or salvage value from the original cost. Furthermore depreciation relates to tangible assets (like equipment or a building) where as amortization relates to intangible assets like a patent or license. Two various methods of calculating depreciation exist, Straight-line and accelerated methods, the former being liberal while the latter is more conservative.
Straight-line is equally divided depreciation charges over the estimated life span of the asset.
Accelerated depreciates an asset more quickly in the beginning of its life (front loaded), which is favourable to minimize taxes but hampers “Headline Earnings Numbers” initially.
Both amortization and depreciation are non-cash expenses.
Now lets assume you own a vehicle and for all things to remain equal. Your car was purchased yesterday, Jan 1st, 2010 for a total of $10,000. Now lets assume you will drive the vehicle to the ground and it will last 10 years. The depreciation under the straight-line method would be a $1,000 expense for each year until the car is longer salvageable or until it is sold .
1000/10 = 100
Now lets imagine that there is a 10-year “sticker” you may purchase for your vehicle (legal requirement) at a total cost of $1,000. Over the life of the “intangible asset” you would expense an amortization charge of $100 annually over the 10-year period.
Now there are various management assumptions to be aware of when looking at the depreciation or amortization of a company. The first being the method used by management, the 2nd is what management deems as the “useful life” of an asset, and finally the salvage value (for which some assets are not easily liquidated). Both depreciation and amortization methods produce different results and lead to different valuation of assets. Next time your looking at financial ratios and valuation metrics ask yourself, what inputs and outputs contribute to these reported figures provided?