There are many different terms and financial concepts incorporated into income statements. Two of these concepts—depreciation and amortization—can be somewhat confusing, but they are essentially used to account for decreasing value of assets over time. Specifically, amortization occurs when the depreciation of an intangible asset is split up over time, and depreciation occurs when a fixed asset loses value over time.
Depreciation Expense and Accumulated Depreciation
Depreciation expense is an income statement item. It is accounted for when companies record the loss in value of their fixed assets through depreciation. Physical assets, such as machines, equipment, or vehicles, degrade over time and reduce in value incrementally. Unlike other expenses, depreciation expenses are listed on income statements as a “non-cash” charge, indicating that no money was transferred when expenses were incurred. Accumulated depreciation is recorded on the balance sheet. This item reflects the total depreciation charges taken to date on a specific asset as it drops in value due to wear and tear or obsolescence. When depreciation expenses appear on an income statement, rather than reducing cash on the balance sheet, they are added to the accumulated depreciation account. Doing so lowers the carrying value of the relevant fixed assets.
Example: Depreciation Expense
For the past decade, Sherry’s Cotton Candy Company earned an annual profit of $10,000. One year, the business purchased a $7,500 cotton candy machine expected to last for five years. An investor who examines the cash flow might be discouraged to see that the business made just $2,500 ($10,000 profit minus $7,500 equipment expenses). To counterpoint, Sherry’s accountants explain that the $7,500 machine expense must be allocated over the entire five-year period when the machine is expected to benefit the company. The cost each year then is $1,500 ($7,500 divided by five years). Instead of realizing a large one-time expense for that year, the company subtracts $1,500 depreciation each year for the next five years and reports annual earnings of $8,500 ($10,000 profit minus $1,500). This calculation gives investors a more accurate representation of the company’s earning power. But, this approach also presents a dilemma. Although the company reported earnings of $8,500, it still wrote a $7,500 check for the machine and has only $2,500 in the bank at the end of the year. If the machine generated no revenue for the next year, and the company’s earnings were exactly the same, it would report the $1,500 depreciation on the income statement under depreciation expenses and reduce net income to $7,000 ($8,500 earnings minus $1,500 depreciation).
Example: Amortization
In a very busy year, Sherry’s Cotton Candy Company acquired Milly’s Muffins, a bakery reputed for its delicious confections. After the acquisition, the company added the value of Milly’s baking equipment and other tangible assets to its balance sheet. It also added the value of Milly’s name-brand recognition, an intangible asset, as a balance sheet item called goodwill. Since the IRS allows for a 15-year period to use up goodwill, Sherry’s accountants show 1/15 of the goodwill value from the acquisition as an amortization expense on the income statement each year until the asset is entirely consumed.
Accounting Entries and Real Profit
Some investors and analysts maintain that depreciation expenses should be added back into a company’s profits because it requires no immediate cash outlay. These analysts would suggest that Sherry was not really paying cash out at $1,500 a year. They would say that the company should have added the depreciation figures back into the $8,500 in reported earnings and valued the company based on the $10,000 figure. Depreciation is a very real expense. In theory, depreciation attempts to match up profit with the expense it took to generate that profit. An investor who ignores the economic reality of depreciation expenses may easily overvalue a business, and his investment may suffer as a result.
Final Thoughts
Value investors and asset management companies sometimes acquire assets that have large upfront fixed expenses, resulting in hefty depreciation charges for assets that may not need a replacement for decades. This results in far higher profits than the income statement alone would appear to indicate. Firms like these often trade at high price-to-earnings ratios, price-earnings-growth (PEG) ratios, and dividend-adjusted PEG ratios, even though they are not overvalued.
