– What is depreciation/amortization on financial statements

Question

– What is depreciation/amortization on financial statements

In: 1

Answer 1

The idea is that when you buy a piece of durable equipment for your business, you don’t expense the entire amount right then (for financial and tax purposes). Rather, you expense a portion of it every single year over the useful life of the equipment. This is because you want to correctly account for how much of that piece of equipment you “used up” every year.

So, for example, you are an electrician and you buy a work truck to drive to your job sites for $50k. You expect the truck will last you for 10 years, so every year you get to expense $5k – the amount of the truck you “used up” during that year. After 10 years – the useful life of the truck – you have expensed the entire $50k

That $5k expense is depreciation.

Amortization works the same way, but it is for intangible goods – you “use up” an intangible good over time, expensing a portion of that every year. For example, you might have a patent that you bought that expires in 10 years. You’d expense 1/10 the price over the next 10 years to account for “using up” the patent over time.

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Bonus answer to the question you didn’t ask – why do we do that? Well, it is because we want to have an accurate picture of profit and loss each year, and large capital expenses can distort that.

Back to our example – I buy my $50k truck for my business, and every year I generate $10k in revenue (we won’t talk about other costs here – lets just assume that I don’t have any other expenses).

Without depreciation, it looks like I lost $40k in year 1, and then made $10k in years 2-10. That isn’t _really_ accurate, because I’m still using the truck every year – the upfront cost is distorting my profits and losses.

By using depreciation, we get a much clearer picture. Every year, I have $5k in profit ($10k in revenue – $5k depreciation). My actual profits are the same every single year because I’ve smoothed out that huge upfront expense. You now have a better picture of how my business is actually performing.