A:

Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally expensed based on the time period over which the asset was used. Both depreciation and amortization (as well as depletion) are methods that are used to prorate the cost of a specific type of asset to the asset's life. It is important to mention that these methods are calculated by subtracting the asset's salvage value from its original cost.

Amortization usually refers to spreading an intangible asset's cost over that asset's useful life. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent, with each portion being recorded as an expense on the company's income statement.

Depreciation, on the other hand, refers to prorating a tangible asset's cost over that asset's life. For example, an office building can be used for a number of years before it becomes run down and is sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year.

Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs are spread out over the predicted life of the oil well.

It is important to note that in some places, such as Canada, the terms amortization and depreciation are often to used interchangeably to refer to both tangible and intangible assets.

For more information, see Appreciating Depreciation.

RELATED FAQS

  1. How does product pricing affect gross profit and EBITDA?

    Learn about how changes in product pricing can affect a company's revenue and profitability, including examples of this effect ...
  2. What is being adjusted in "adjusted net income"?

    Understand the difference between net income and adjusted net income, including which items factor into the adjustment and ...
  3. What is the difference between earnings and revenue?

    Understand how a company makes revenue and how it makes earnings. Learn the difference between revenue and earnings and how ...
  4. What is the difference between earnings and income?

    See how earnings and income are different and when they are used in relation to personal finance versus a business' financial ...
RELATED TERMS
  1. Chart Of Accounts

    A listing of each account a company owns, along with the account ...
  2. Convention Statement

    A document filed by an insurance or reinsurance company that ...
  3. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative ...
  4. Nonadmitted Balance

    An item on an insurer’s balance sheet that represents reinsured ...
  5. Earned Premium

    The amount of total premiums collected by an insurance company ...
  6. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...

You May Also Like

Related Articles
  1. Fundamental Analysis

    How does product pricing affect gross ...

  2. Investing Basics

    What is being adjusted in "adjusted ...

  3. Stock Analysis

    How To Analyze Netflix's Income Statements

  4. Fundamental Analysis

    The Most Crucial Financial Ratios For ...

  5. Stock Analysis

    How Does Biogen Make its Money?

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!