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The terms depreciation and amortization have various meanings in finance and investing. For example, depreciation can refer to the devaluation of a currency, and amortization can be used to describe the payment structure in a common type of loan. The words are only directly comparable, however, when they are used in accrual accounting. In this field, both describe a method of allocating the initial expense of an asset over its useful life, so that in each period the revenues from the asset can be matched with a portion of its expense. They differ in the types of assets to which they apply.
Depreciation is applied to tangible assets, while amortization refers exclusively to intangible assets. Both involve an estimation of the asset’s useful life, or the period over which it will generate profit. The useful life of a physical asset that must be depreciated is the time after which the asset must be replaced; allocating the expense smoothly over this period requires accountants to predict the period in which an asset will cease to be valuable. Amortization is somewhat more straightforward, as the useful life of an intangible asset ends at its expiration date. For example, patents usually last for 17 years, so the price of obtaining the patent may be spread evenly over this period.
Accountants use depreciation and amortization to spread out the cost of an asset. The proportion of the value of the asset that is depreciated or amortized in a given year is equal to the proportion of the asset’s lifetime profit that is expected to be realized during that year. One reason for this practice is that accountants may write off part of the expense on each year’s taxes. Another reason is that depreciation and amortization can avoid frightening investors with high initial expenses.
If a company could not depreciate its investments, its accounting statements might show a sharp decrease in profits whenever it replaced expensive machinery. This could discourage investment. The company’s overall profitability, however, would be constant because the machine generates enough profit to justify the initial expense, so depreciating the cost of the machine would be more indicative of the company’s potential to an investor.
The accounting statements of a company do not accurately reflect how much cash the company has on hand because of depreciation and amortization practices. A large purchase in one year could leave the company unable to meet its obligations, even though its accounting statements show that it should have sufficient funds. Cash flow statements reflect the reality of the company’s holdings.
Depreciation and amortization only apply to assets whose values are expected to decrease. If a company decorates its headquarters with a painting that is expected to appreciate in value, it may not split up the cost on its accounting sheets because the painting will not depreciate over time. Land may not be depreciated because it has an infinite useful life. Similarly, indefinite trademarks may not be amortized because they could become more valuable. The terms are also inapplicable to natural resources: they are used up in a process known as depletion.