If you ask any newly qualified accountant what they find hardest, they will almost certainly answer depreciation and amortization. But why do people find these two concepts so hard to master?
Well, for one thing depending on where you are located the terms may mean the same thing, or may have decidedly different meanings.
Both depreciation and amortization are key aspects of accrual accounting and need to be mastered by anyone wanting to make a career in accountancy. The aim of both depreciation and amortization are to allocate the cost of an asset over the life of the asset. To do this they need to carry over an expense account containing each year’s depreciation figure.
As depreciation deals with tangible assets and amortization deals with intangible assets, we usually find that depreciation is more commonly understood because we can visualize the process easier. However, the various methods of depreciation can confuse the matter greatly.
There are multiple methods of depreciating an asset, based either on time or the activity of the asset. The most common of these are:
Straight line depreciation, in which the company calculates the salvage value of the asset and then depreciates a set percentage over the useful life of that asset until the net-book value reaches the salvage value. This is considered to be the simplest method of depreciation, and as such is the most commonly used.
The sum-of-years-digits depreciation method is again based on time passing but is a considerably more complicated method than the straight line method. It is used because it results in accelerated depreciation of an asset. When using this method, the first thing to do is to determine the year’s digits figures. For example, on an asset with a useful life of five years these would be: 5, 4, 3, 2, 1. Then calculate the sum of the figures, in this case 15. To get the depreciation rate we then divide the years digits figures by the sum of figures, so in the first year the depreciation rate would be 5/15, in the second year 4/15 etc. The result of this is that the asset depreciates quicker at the start of its useful life than at the end.
Annuity depreciation is a method which is not based on time, but rather on cost. When the asset is purchased its useful life is established and from this the ‘number of uses’ estimated. This could be miles traveled in the case of a vehicle or cycle turns in the case of a production machine. This figure is then divided by the difference between the cost and the salvage value of that asset, which gives a unit cost. Each year, the depreciation is calculated on the actual usage of that asset by multiplying the unit cost.
Units of time depreciation works along a similar principle, but instead of a unit of use the depreciation is calculated on a unit of time. This is used particularly when the asset is not expected to be in use for the whole linear year.
The choice of depreciation method is determined by the type of asset.
Amortization of intangible assets is calculated in a similar way to the straight line depreciation method with the notable exception of the useful life of the asset. The first thing to do is to determine whether the asset has an infinite or finite life. An asset with a finite life might be constricted by laws or regulations which prohibit its use after a certain amount of time. An asset with an infinite life, such as goodwill, cannot be amortized. Once you have the useful life of the asset, you need to determine the net book value of the asset, which is typically the cost of purchase. Then amortization occurs as in the straight line method until the net book value of the asset reaches zero at the end of its useful life. Certain intangible assets may have a salvage value, if they are able to be re-sold at the end of their useful life. In this case, the net book value will decline year on year until it reaches the expected re-sale price.
Both depreciation and amortization present one major problem. The total cost of the asset is paid in full in the first year but is accounted for over the useful life of the asset. Therefore the company's actual current cash-flow situation can be misrepresented in the accounts during this time.