3.7: Depreciation and Amortization Effect

Depreciation and amortization are accounting methods used to allocate the cost of long-term assets over their useful lives. Depreciation applies to tangible assets like machinery or buildings, while amortization relates to intangible assets such as patents or trademarks. These are non-cash expenses, meaning they reduce accounting profits without involving actual cash outflows during the period.

When depreciation and amortization are recorded, they lower the net income reported on the income statement. This reduction in reported profit can affect profitability ratios, such as net profit margin or return on assets, making a business appear less profitable even when its cash flow remains strong. For example, a company may generate steady cash from operations, but high depreciation on new equipment could significantly lower net income.

Despite reducing reported profits, these expenses can be beneficial from a tax perspective, as they reduce taxable income. Investors and analysts often look at alternative profitability metrics, like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), for a clearer view of operational performance. Understanding the impact of depreciation and amortization helps evaluate a company’s financial health and compare firms with different capital investments or asset structures.

Depreciation and amortization are accounting methods used to allocate the cost of assets over time.

Depreciation applies to tangible assets like machinery, while amortization applies to intangible assets like patents.

These non-cash expenses reduce a company’s reported profits without affecting its cash flow.

For example, Delta Corporation’s total revenue is one hundred fifty thousand dollars in a given year, with other operating expenses totaling eighty thousand dollars and depreciation expenses of ten thousand dollars. The profit before depreciation would be seventy thousand dollars.

After accounting for depreciation, the reported profit drops to sixty thousand dollars.

Taxing authorities, such as the IRS, also permit depreciation of assets using approved depreciation methods.

Since depreciation and amortization do not impact actual cash flow, they do not reduce the corporation’s ability to reinvest or pay dividends.

As a result, these methods help present a more accurate picture of long-term profitability and asset utilization.

Understanding depreciation and amortization is essential for evaluating Delta Corporation’s profitability and financial health.