How to Use Depreciation and Amortization for Your Financial Reports - dummies

How to Use Depreciation and Amortization for Your Financial Reports

By Lita Epstein

Depreciation and amortization are accounting methods you use to track the use of an asset on your financial reports and record its value as it ages. Tangible assets (assets you can touch or hold in your hand) are depreciated (reduced in value by a certain percentage each year). Intangible assets (like intellectual property) are amortized (reduced in value by a certain percentage each year).

For example, each vehicle a company owns loses value throughout the normal course of business every year. Cars and trucks are usually estimated to have five years of useful life, which means the number of years the vehicle will be of use to the company.

Suppose a company pays $30,000 for a car. To calculate its depreciation on a five-year schedule, divide $30,000 by 5 to get $6,000 in depreciation. Each of the five years this car is in service, the company records a depreciation expense of $6,000.

When the company makes the initial purchase of the vehicle using a loan, it records the purchase this way:

Account Debit Credit
2008 ABC company car $30,000
Loans payable — Vehicles $30,000
In this transaction, both the debit and the credit increase the
accounts affected. The debit recording the car purchase increases
the total of the assets in the vehicle account, and the credit
recording the new loan also increases the total of the loans
payable for cars.

The company records its depreciation expenses for the car at the end of each year this way:

Account Debit Credit
Depreciation expense $6,000
Accumulated depreciation — Vehicles $6,000
In this case, the debit increases the expense for depreciation.
The credit increases the amount accumulated for depreciation. The
line item Accumulated depreciation — Vehicles is
listed directly below the asset Vehicles on the balance
sheet and is shown as a negative number to be subtracted from the
value of the Vehicles assets.

This way of presenting the information on the balance sheet helps the financial report reader quickly see how old an asset is and how much value and useful life it has. Some financial reports only show the net value of an asset with deprecation already subtracted. In those cases the financial report reader may need to find the detail in the Notes to the Financial Statement.

A similar process, amortization, is used for intangible assets, such as patents. Just as with depreciation, a company must write down the value of a patent as it nears expiration. Amortization expenses appear on the income statement, and the balance sheet shows the value of the asset.

The line item Patent is shown first on the balance sheet, with another line item called Accumulated amortization below it. The Accumulated amortization line shows how much has been written down against the asset in the current year and any past years. The financial report reader thus has a way to quickly calculate how much value is left in a company’s patents.