Depreciation & Amortisation

Demystifying Key Aspects of Long-term Asset Management

Compact Explanation

Depreciation & Amortisation is the reduction in value of an asset over time.

Introduction

In the ever-evolving landscape of financial analysis, understanding terms like "Depreciation" and "Amortisation" is paramount. These two concepts play a crucial role in the management and evaluation of long-term assets.

This comprehensive guide aims to shed light on these essential financial terms.

Definition

Depreciation refers to the gradual decrease in the value of a tangible asset over its useful life due to wear and tear, physical deterioration, and age. Amortisation, on the other hand, is the gradual reduction of an intangible asset's value or a liability (such as a loan) over a specified period.

Context and Use

Depreciation and amortisation are critical in financial accounting and analysis. They affect various aspects of a business, including profit calculation, tax computation, and capital budgeting. They also feature prominently on the income statement and balance sheet, impacting the overall representation of a company's financial health.

Detailed Explanation

Depreciation applies to physical assets like machinery, equipment, and buildings. A company can choose from several methods of depreciation, including straight-line, declining balance, and units of production. The choice depends on the asset's nature and the company's accounting policies.

Amortisation typically applies to intangible assets like patents, trademarks, goodwill, and software. Just as with depreciation, there are different methods of amortisation. However, the straight-line method, which divides the asset's cost evenly over its useful life, is most commonly used.

Examples

1. Depreciation: If a company purchases machinery for $100,000 with an expected useful life of 10 years and a residual value of $10,000, using the straight-line method, the annual depreciation would be ($100,000 - $10,000) / 10 = $9,000.

2. Amortisation: If a company purchases a patent for $50,000 with a useful life of 5 years, using the straight-line method, the annual amortisation would be $50,000 / 5 = $10,000.

Related Terms

• Asset Life: The estimated period during which an asset is expected to be economically useful.

• Residual Value: The estimated value of an asset at the end of its useful life.

• Capital Expenditure (CapEx): Funds used by a company to acquire, upgrade, and maintain physical assets.

Frequently Asked Questions (FAQ)

1. What's the difference between depreciation and amortisation? Depreciation applies to tangible assets like machinery and buildings, while amortisation pertains to intangible assets like patents and trademarks.

2. Why are depreciation and amortisation important? They allow companies to allocate the cost of an asset over its useful life, affecting profits, tax computations, and the representation of a company's financial health.

3. How do depreciation and amortisation impact the income statement? They are recorded as expenses, reducing the company's net income on the income statement.

4. Can the methods of depreciation and amortisation be changed? Yes, but changes must comply with the relevant accounting standards and need to be justified and adequately disclosed.

5. What happens if an asset is fully depreciated or amortised? Once fully depreciated or amortised, the asset remains on the balance sheet at its residual value, but no further depreciation or amortisation expense is recorded.

6. How do depreciation and amortisation affect cash flow? Depreciation and amortisation are non-cash expenses. They reduce net income but do not impact cash flow, thus they're added back in the cash flow statement.

Key Takeaways

Depreciation and amortisation are pivotal in the accounting and evaluation of long-term assets. They influence profit calculations, tax computations, and the representation of a company's financial health.

Conclusion

Understanding depreciation and amortisation is fundamental for investors, financial analysts, and business owners. It aids in informed decision-making, offering insights into a company's asset management, profitability, and overall financial health.

Disclaimer: This article is meant to provide a general understanding of the financial terms "Depreciation" and "Amortisation". It should not be construed as financial advice. Each individual and company's financial situation is unique, and it's recommended to consult with a certified financial advisor before making any investment or financial decisions. The author and publisher disclaim responsibility for any financial decisions made based on this information.