The terms depreciation depletion and amortization are often used to mean the same thing, the reduction in the value of an asset. Most assets have a limited life and therefore reduce in value over time. An estimate of this reduction in value is charged as an expense to the income statement each accounting period.
To be more specific about the terms depreciation depletion and amortization, we will look at an example of each.
Depreciation refers to the wear and tear of a physical asset due to it being used, and is therefore applied to tangible assets.
For example, if a machine is purchased for 12,000 and is expected to have a useful life of 5 years, and a salvage value of 2,000, then the depreciation expense is given by the formula.
In this case the depreciation expense is equal to (12,000 – 2,000) / 5 = 2,000 a year
The machine is expected to reduce in value due to being used over the five year period. The cost to the business of this wear and tear is 2,000 a year.
Depletion means to exhaust the supply of a resource. In this case the asset is the cost of extracting the resource which needs to be depleted as the resource is extracted. There is no wear and tear, the natural resource is simply being used.
For example, if a business is mining for a coal, and has expenditure of 1,500,000 on purchasing, exploring, and developing the coal mine, this expenditure is an asset of the business which will reduce in value as the coal is extracted.
The expenditure on the mine is therefore the cost of getting the coal and is depleted as the coal is extracted. When all the coal has been extracted the asset will have zero value.
Now if the amount of coal in the mine is expected to be 200,000 units, then the depletion expense is given by the formula:
In this case the depletion expense is equal to 1,500,000 / 200,000 = 7.50 per unit
So if in an accounting period 10,000 units are extracted, the depletion expense would be 10,000 x 7.50 = 75,000.
Amortization quite literally means to ‘bring to death, and is the gradual extinction of an intangible asset or liability by periodic amounts. In this case there is no physical substance to the asset or liability, there is nothing to wear and tear over time, so the term depreciation is not applicable.
For example, an intangible asset such as a patent might have cost 40,000 and have a ten years of its useful life remaining. The amortization expense is given by the formula:
In this case the amortization expense is equal to 40,000 / 10 = 4,000 a year.
An item which sometimes causes confusion is that leasehold improvements are said to be amortized not depreciated. The reason for this is that the physical assets resulting from the improvements belong to the landlord not the tenant. What the tenant has done is improve the value of an intangible asset, the leasehold, so the improvements are amortized over the remaining lease term.
In the case of a liability, a loan of 20,000 might be repaid in 10 installments of 2,000 per year.
The value of the loan on the balance sheet reduces over time, and the loan is said to be amortized over the ten year period.