What is Depreciation and Amortization? Reasons for Depreciation and Amortization : How does it Work? Methods to Calculate Depreciation and Amortization - financebrother

Depreciation and Amortization
These are the two accounts that reflect the utilization of tangible and intangible assets.

 

What is Depreciation?

It is the reduction in the recorded value of the tangible fixed assets on the balance sheet in a systematic lifecycle until the asset is totally scrapped.

It is a proportion of the cost of the fixed asset to generate the revenue from that asset.

Reasons for Depreciation and Amortization

The reasons are:

1. Obsolesce
2. Daily wear and tear
3. Change in Technologies
4. Reducing Production Capacity.

 

How Does Depreciation Work?

Suppose you purchase a vehicle for delivery of your goods and service costing $1 million and the useful life of the vehicle is 5 years.

 

Depreciation Charge on this vehicle = Cost/Useful Life

Depreciation = $1 million/5 = $0.2 million.

 

What is Amortization?

It is the same as depreciation but it is charged on intangible fixed assets. Such as (Computer Software, costs incurred in creating some intellectual property rights which have predetermined fixed terms.

 

Methods to Calculate Depreciation and Amortization

 

Straight Line Method (SLM): In this method of calculating Depreciation and Amortization, the value will reduce uniformly until the asset reaches its scrap value. 

 

Example: Suppose you purchase a Machinery costing $2 million and charge depreciation @10% per year, having scrap value of $0.2 million.

 

Depreciation = $2 million * 10% each year until machinery reaches $0.2 million

Depreciation = $0.2 million will be charged each until the value reaches $0.2 million. 

Hence, the useful life of the assets = 9 years

 

Diminishing / Reducing Balance Method: In this method, the Depreciation and Amortization will be charged on the balance amount of the assets until the asset reach to its scrap value. In this method, the depreciation you calculate reduces year by year as the book value of the asset falls post decreasing depreciation.

 

Example: Suppose you purchase Furniture for your office, costing $5 million and charging depreciation @20% per year.

 

1st year Depreciation = $5 million * 20% 

                                   = $1 million

 

Remaining Value of the Furniture = $5 million - $1 million

                                                      = $4 million

 

2nd year Depreciation = $4 million * 20%

                                    = $0.8 million 

 

Remaining Value of the Furniture = $4 million - $0.8 million 

                                                     = $3.2 million 

And so on…