Lesson 56: Depreciation, Amortization and Depletion
In this lesson, we will define depreciation and cover how it is used. We will
also compare depreciation, amortization and depletion and learn 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.
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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.
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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.
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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.