Explanation of the Concepts of Depreciation & Amortization
Depreciation and amortization are similar, but not identical, accounting transactions. They are estimates for how much assets cost a firm over time. Assets, such as a building, will eventually wear and become a greater liability over time, so the process of this wear must be recorded because, although somewhat abstract, it is a true business expense.
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Features
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Depreciation and amortization are both estimates of the loss of value of a specific asset. The main difference is that depreciation refers to assets that have a physical presence, such as buildings or machines. On the other hand, amortization refers to nonphysical assets, such as trust, goodwill, business plans or patents.
Function
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Depreciation is something that is spread out over time. An accountant will record it as an expense on the firm's income statement. Using a simple example, a firm buys a fleet of delivery trucks for $500,000. It is expected that these trucks will wear out and be resold in five years. Therefore, the accountant will record a $100,000 expense per year for the fleet. This estimate, while rough, is likely more accurate than the amortization estimate. This is because amortization refers to things that do not “wear.” If a patent on a new medicine is going to expire in 20 years, the estimate of the cost of that patent to the firm is deducted as an expense for each of those years. In other words, the cost of developing the medicine (that led to the patent) is spread out over time.
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Problems
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The main problem with these concepts is measurement. It is difficult to predict how a fleet of trucks will wear over five years, since this kind of depreciation is often uneven. There is no sense of accuracy with amortization, in that an even number is just spread out over the life of something like a patent or an investment plan. Since amortization can also be used for other valuable, but intangible assets like trust, such measures are more general and can never be perfectly accurate.
Benefits
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Especially in business where physical labor is intensive, it is immensely important that the wear and tear on physical capital be recorded. In areas like mining, construction or steel production, extreme temperatures and other intense situations take a toll on physical capital. Constant attention to this wear is the real benefit of accurate depreciation models. For amortization, intangible assets such as community (which produces trust) are important to rational business models and expectations. Therefore, attention to them is central.
Significance
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These concepts prove that business is not an exact science. Business, however, demands numbers and proper accounting procedures to function. The results develop as estimates. Further, the value of assets does not remain stable over time. Spreading out the costs of these assets make good business sense. The existence of amortization shows how important ideas like goodwill are to business, even though trying to put a dollar amount on it is a little strange. The asset does, however, have real business value, and therefore, must be recorded.
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