Lesson Objectives:- Defining depreciation and how it is used
- Comparison of depreciation, amortization and depletion
- What types of assets each method is used for
Let's start with the topic of depreciation as it will set the framework for comparing depreciation with the concepts of amortization and depletion.
Depreciation is the method that is used to allocate an asset's cost over the time period of its useful life. It basically defines how the cost for the asset is allocated. This term is used for tangible assets such as equipment, buildings, vehicles and other physical items.
Let's say a company purchases a piece of machinery for $18,000. In order to add the asset to their books, they will need to record a journal entry for the purchase. The equipment asset account would be debited by $18,000 since it is increasing and the cash account would be credited for $18,000 as it is decreasing.
We have capitalized the equipment as an asset as opposed to expensing the purchase. The reason for this is because at the time of purchase, the company has not yet used the machine and expense entries are normally associated with use.
What we will need to do is allocate the cost of the equipment asset over its useful life. Let's say the estimated life of the machine is 10 years. To determine how much cost should be expensed each year, we would simply divide the $18,000 purchase by 10 years to come up with an expense of $1,800 each year.
If we are following the matching principle, it wouldn't make any sense to expense the entire asset when it is purchased. Since we need to match the expenses to the revenues earned each year, the company would need to show a journal entry each year for $1,800 to show the depreciation expense. This method will allow them to allocate the cost of the machine over its expected life and remain in compliance with the matching principle.
Next, let's talk about amortization which involves intangible assets as opposed to physical assets.
The difference between depreciation and amortization is that depreciation deals with tangible assets while amortization covers intangibles such as trademarks, copyrights and patents. Client lists can even be considered an intangible asset for certain companies.
Amortization deals with items that cannot be physically touched or held, but it can also serve as a general term to allocate cost of any type of asset. This explains why amortization is most frequently used to describe the expense of tangibles, intangibles and natural resources.
Although amortization covers natural resources, there is a third method known as depletion that is exclusive to this type of asset.
Companies that own assets such as gold mines and oil rigs use depletion to record their expenses based on the amount of the natural resource they are using. The use of the particular resource must be recorded in order to match the consumption expense with the revenue that the company has earned within a specific accounting period.
The table above describes which types of asset costs are allocated under each method. Although, keep in mind that amortization can cover any type of asset cost and often serves as a general expense allocation method.