Depreciation and Amortization—The Slow Draw

May 2005

We have been focusing on the income statement for a few months now‐and there is one term on the income statement that hangs many folks up‐it is depreciation. Depreciation is the reduction in value of a fixed asset over time. Amortization is the reduction in value of an intangible asset over time‐for instance a copyright, patent, or research and development expense.

“Thanks for sharing, Leita!” you may be saying to yourself. I hope you are going to tell me more. Yes, I am.

Let’s focus on depreciation first and I’ll explain amortization in more detail later.

Why depreciate?

We depreciate because we don’t want to mislead the readers of our financial statements. If we buy a computer today, is it worth as much in a year? In two years? We don’t want to leave an overvalued asset on our books so that the users of our financial data think we have all new stuff. We should be honest with them about the real worth of our fixed assets and the likelihood that we will have to buy new computers to replace the old ones soon.

Another reason we depreciate is that we don’t want to absorb the full hit of the cost of the computer in our net income in the year we purchase it. We prefer to spread the impact out over a longer period. We are going to use the computer for years to come and we accountants think it is fair to acknowledge that the computer will help us generate net income for several more years. So, depreciation allows you to spread the cost of the computer over the years of its useful life and slowly, slowly acknowledge its impact on bottom-line net income.

Example computer purchase

Let’s say that you purchased a $6,000 computer with cash (yes, that is a lot of money for a computer, but it is a round number, so hang with me). Now, there are two ways to treat your purchase. You can expense or capitalize the computer.

Each choice has different income statement and balance sheet consequences. Both the expensing method and the capitalizing method have the same exact effect on cash flow (FYI, the income statement, the balance sheet,and the cash flow statement are the three key financial statements that businesses use to make decisions).

Let’s do the easy one first‐let’s “expense” the computer.

Expensing a computer

If we expense the computer, we will hit the income statement for the entire expense of the computer in the year that we purchase it.

Here is the income statement example we used last month‐changed just a tad to make learning easy here:

Now, let’s buy that computer and expense it:

So our bottom line, our net income, was reduced from $15,000 to $9,000.

What happens on the balance sheet?

Expensing causes a simple impact on the balance sheet. The reduction in net income impacts our retained earnings and the purchase amount reduces our cash balance. I am going to skip some of the complexity caused when I add numbers to the balance sheet and just summarize the impact to the different accounts.

What happens to cash?
Cash is reduced by $6,000.

Capitalizing the computer

That word “capital” is my least favorite finance term ever. The word “capital” is applied to so many things, it is almost meaningless. But we traditionally use it here, nevertheless.

When you capitalize the computer, it means that you record it as a fixed asset and depreciate it. You spread the cost of the computer out over a number of years.

Let’s just make things easy on ourselves, and say that the useful life of the computer is three years and we use the simplest method of depreciation ever‐straight-line depreciation. (The IRS has much fancier and more complicated ways of depreciating an asset and they dictate how long the useful life of a computer is for tax purposes.)

So straight-line depreciation says that the depreciation amount is the same each year. So $6,000 divided by three years = $2,000 in depreciation expense every year.

So here is the impact on the income statement:

So, instead of a $9,000 bottom line, we have a better-looking $13,000 bottom line.

What happens on the balance sheet?

OK, this is a little more complex than expensing it. What you do is record the full value of the computer as a fixed asset and then reduce that value by the current year’s depreciation.

*Often this is disclosed as
Fixed assets = $6,000
Less depreciation expense of $2,000
= Net fixed assets of $4,000

What happens to the cash flow statement?
The same thing that happens when you expense it. You are out $6,000 cash.

Decisions! Decisions!

OK, which one of those net income figures do you want to share with investors? Yes, the $13,000 net income you get when you capitalize the asset and depreciate it. Which of the two figures do you want to show to the IRS? Yes, the $9000 net income you arrive at when you expense it. Hmmm. What to do?

Well, here is one place that an accountant can help you. A good tax accountant can spell out the long-term consequences of your decision.

Mind you, the choice I spelled out for you may not even be your choice. The IRS has strict rules about what can be depreciated and for how long. For instance, the IRS would never let you expense a $3 million building. They are going to make you depreciate it over more than thirty years‐ yes over thirty years. It would be unfair to the federal government for you to get out of paying taxes because you bought a building. (Please note that I am making this MUCH, MUCH simpler than it really is and probably causing tax experts a coronary.)

Summary

So depreciation lets you recognize that you will be using the asset over several years and allows you to spread that cost over those years, so you don’t have to take a hit to the bottom-line in the year of purchase. Depreciation also allows you to acknowledge that your stuff is getting old and that you may have to replace it someday.

What is “amortization”?

Amortization is the depreciation of intangibles or other expenses that don’t end up as a “thing”‐a fixed asset.

For example, you would amortize, not depreciate, the value of a patent over its useful life. Many organizations accumulate the cost of research and development on a new product and then amortize the cost over the sales life of the product. In this way they do not have to show a horribly low net income in the year of development and inflated net income in the sales years.

I say “inflated” because we have a guiding concept in accounting called the matching principle. The matching principle says that you should match the expenses to the revenues they helped generate. This keeps things net income more even over time than if you recognized the expenses and revenues in different periods. Wild fluctuations in net income may lead investors to think the company is unstable or manic depressive.

Whew. That was the longest newsletter yet!

Next month, we are moving on from the income statement to the cash flow statement, the most intuitive financial statement of them all.