Just for info
4. How does amortization differ from depreciation?
A. This is a great question, especially in this era of so many knowledge companies. It also involves a detailed answer that must be broken down into three components.
B. For my first component, I can give a simple answer to your question, because there are many similarities between depreciation and amortization. So let's first review how depreciation works. When a company buys a tangible asset, such as an expensive machine that it does not intend to sell and expects to generate value over a long life, accounting rules do not allow the company to expense the total machine cost in the year the machine is acquired.
C. This is because that an accrual-accounting income statement is predicated on telling how well a company was making money on the products and services it sold during the period under review. So, to this end, a portion of the total cost of the machine needs to be expensed to each period over the expected useful life of the machine. Often the spread involves an equal amount for each period, which is called straight-line depreciation. So that's how a tangible asset gets depreciated.
D. Amortization is similar to depreciation, except that it deals with intangibles, such as all costs paid to outsiders to acquire a patent, a portion of which needs to be expensed to each period over the legal life of the patent. If the total cost of the machine or the patent were expensed all to the year of acquisition, year 1 profit would be understated and profit for subsequent years (when the asset was creating value) would be overstated. There are many other examples of intangible amortization, such as long-term debt reduction, leasehold improvement, and goodwill, each of which also has its own nuances.
E. The hot topic this year is goodwill amortization, which brings in my second component, that of defining goodwill. Goodwill is an asset that occurs on the books of a company that acquires another company. Now, the acquiring company first lists on its balance sheet all the other assets acquired, such as cash, receivables, inventory, and fixed assets, all at the estimated fair value of each line item, in as-is condition, on the date of acquisition. But usually the acquisition price exceeds the value of all these standard types of assets; the resulting dollar difference is called goodwill.
F. By booking the difference as goodwill, the balance sheet will now balance and, as you know, this is a good thing. But goodwill also shows the value that the acquiring company has agreed to pay for all the other intangible assets that are difficult to quantify, such as customer lists, employee morale, uniquely successful culture components, intellectual property, and research and development. In this knowledge economy, goodwill has become a much more significant part of many balance sheets; sometimes it is the biggest asset on the balance sheet. But remember that goodwill does not show up on a balance sheet unless there has been an acquisition.
G. My third component deals with amortizing this intangible over its estimated useful life, which we covered earlier. But goodwill amortization is no longer easy because the rules I shared with you earlier are no longer valid. Beginning in 2002, goodwill is no longer to be written off over its useful life (amortized). Instead, goodwill dollars are now supposed to remain unchanged on the acquiring company's balance sheet forever.
H. (Incidentally, if you are wondering why the old rules for goodwill amortization sufficed for many years, only to suddenly change, you may be relieved to know that I have the same concern and no truly valid answer; accounting in the USA obviously has some major weaknesses, as you can see here. However, I also believe that the information in my first and second components incorporates some of the many strengths of accounting in the USA.)
I. Interestingly, there is now one exception to leaving goodwill on the balance sheet forever. Whenever a company can no longer justify that the goodwill value showing on the balance sheet is still true, the company must write down the goodwill value to the lower estimated actual current value, even if this means writing it down to zero. But this actual current value is not always readily determinable, so company judgment is required. Of course, this judgment can lead to creative accounting. And the dollars involved are usually major.
J. Furthermore, it is now difficult to do trend analysis on net income, because, prior to 2002, goodwill amortization always reduced net income. So, without taking hard-to-find footnotes into account, a trend analysis using net income in an annual report will no longer compare apples to apples. A suggested solution to this dilemma is to use an outside resource such as Value Line, which readily provides the necessary information needed to compare apples to apples in a trend analysis.
K. Now I hope we answered your question about the difference between depreciation and amortization. I apologize that I could not give a simpler answer. However, this lengthy answer seems also to be a commentary on how accounting just "ain't" simple anymore, like it supposedly used to be. Bummer.
Note added at 1 hr 36 mins (2003-12-08 02:48:22 GMT)
D. Amortization is similar to depreciation, except that it deals with intangibles
| Andy Watkinson|
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