Learn about depreciation and amortization — Stock-Market notes

Core Concept

Depreciation and amortization are non-cash expenses that allocate the cost of long-term assets over their useful life. They reduce reported profit BUT don't reduce cash (the cash left when you bought the asset).

WHY this matters for investors:

These expenses lower net income but don't touch cash flow
Companies with heavy assets (factories, equipment) show lower profits than cash-generating ability
Understanding this prevents mistaking "low profit" for "bad business"

Depreciation vs Amortization

WHY the split? Accounting standards categorize by physical nature. Both answer: "How much of this asset's value did we 'use up' this year?"

Depreciation Methods

1. Straight-Line Method (Most Common)

WHY this formula? We're dividing the depreciable amount (cost minus what we'll recover) evenly across the years we'll benefit from it.

Worked example Straight-Line: Manufacturing Equipment

A factory buys a CNC machine for $500,000**. Installation costs **$ 20,000. Estimated salvage value after 10 years: $20,000.

Step 1: Total cost = $500k +$ 20k = $520,000 Why add installation? It's necessary to make the asset usable.

Step 2: Depreciable amount = $520k -$ 20k = * $500,000** *Why subtract salvage? We'll recover that$ 20k, so we didn't really "lose" it.

Step 3: Annual depreciation = $500k ÷ 10 = **$ 50,000/year** Why divide by 10? Equal expense each year the machine helps us make products.

Journal entry each year:

Depreciation Expense     $50,000  (Income Statement↓)
   Accumulated Depreciation      $50,000  (Balance Sheet ↑)

After 5 years:

Book value = $520k - (5 ×$ 50k) = $270,000
This is NOT market value, just accounting value

Figure — Learn about depreciation and amortization

2. Accelerated Methods (Tax Benefits)

Declining Balance Method

WHY accelerate? Assets often lose value faster early (new car loses20% driving off the lot). Also, tax strategy: bigger deductions now → lower taxes now → time value of money benefit.

Worked example Accelerated: Company Car

Company buys a car for $40,000**, salvage **$ 4,000, 5-year life.

Straight-line rate = 1/5 = 20% → DB rate = 2 × 20% = 40%

Year	Book Value Start	Depreciation (40%)	Book Value End
1	$40,000	$16,000	$24,000
2	$24,000	$9,600	$14,400
3	$14,400	$5,760	$8,640
4	$8,640	$3,456	$5,184
5	$5,184	$1,184*	$4,000

*Year 5: Can only depreciate to salvage value, so $5,184 -$ 4,000 = $1,184

Why this step in Year 5? We can't depreciate below salvage value—that's our floor.

Total depreciated = $36,000 (same as straight-line), just front-loaded.

Units of Production

WHEN to use? Asset wear depends on use, not time (oil rigs, factory machines).

Amortization of Intangibles

SAME straight-line logic, but:

Intangibles usually have no salvage value (a used patent is worthless)
Some intangibles (trademarks) have indefinite life → NOT amortized, tested for impairment instead

Worked example Amortization: Patent Purchase

Pharma company buys a drug patent for $10 million. Patent expires in 8 years.

Annual amortization = $10M ÷ 8 = **$ 1.25M/year**

Why 8 years? Legal life of the patent = useful life. After 8 years, anyone can make the drug.

Journal entry:

Amortization Expense        $1,250,000  (Income Statement ↓)
   Accumulated Amortization             $1,250,000  (Balance Sheet ↑)

Impact on Financial Statements

Income

Depreciation/Amortization Expense reduces operating income
Appears in Operating Expenses section or Cost of Goods Sold (if factory equipment)

Balance Sheet

Accumulated Depreciation is a contra-asset account (subtracts from asset value)
Net Book Value = Original Cost - Accumulated Depreciation

Worked example Balance Sheet Presentation

Property, Plant & Equipment:
  Machinery (at cost)              $500,000
  Less: Accumulated Depreciation  ($200,000)
  Net PP&E                         $300,000

Why contra-account? Shows both what we paid (historical cost) and how much we've used (accumulated depreciation). Transparency.

Cash Flow Statement

Operating Cash Flow: Add back depreciation/amortization to net income
WHY? It reduced net income but didn't use cash → we're reversing the "fake" reduction

Formula Operating Cash Flow Adjustment

$\text{Operating Cash Flow} = \text{Net Income} + \text{Depreciation} + \text{Amortization} + \text{other non-cash items} \pm \text{working capital changes}$ This is why EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) is popular—it approximates cash generation.

Note: To go from Operating Cash Flow to Free Cash Flow, you then subtract capital expenditures: $\text{Free Cash Flow} = \text{Operating Cash Flow} - \text{Capital Expenditures}$

Common Mistakes

Tax Strategy: Book vs Tax Depreciation

Key insight: Companies use two sets of books (legally):

Book depreciation (for shareholders): Often straight-line, smooths earnings
Tax depreciation (for IRS): Often MACRS (Modified Accelerated Cost Recovery System), front-loaded

WHY? Maximize tax deductions early → pay less tax now → invest that cash. This creates deferred tax liabilities (you'll pay more tax later when book depreciation exceeds tax depreciation).

Worked example Book-Tax Difference

Equipment costs $100k, 5-year property, no salvage.

Book (straight-line): $20k/year

Tax (actual MACRS 5-year table, with half-year convention):

Year	MACRS %	Tax Depreciation
1	20.00%	$20,000
2	32.00%	$32,000
3	19.20%	$19,200
4	11.52%	$11,520
5	11.52%	$11,520
6	5.76%	$5,760

Why does Year 1 = only 20%, not 40%? MACRS uses a half-year convention: the asset is assumed placed in service mid-year, so Year 1 gets a half-year of depreciation. The peak deduction lands in Year 2 (32%).

Year 2 impact:

Book income: Revenue - $20k depreciation
Taxable income: Revenue - $32k depreciation → lower taxes that year
Difference: $12k temporary timing difference → deferred tax liability

Why this matters for investors: Front-loaded tax deductions mean lower cash taxes early → more cash for growth. Check the cash flow statement and the tax footnote, not just net income.

Investor Analysis Checklist

Recall Key Questions When Analyzing

What depreciation method does the company use for its BOOKS? (Check the footnotes in the 10-K)
- Accelerated book method → lower early profits (more conservative reported earnings)
- Straight-line → smoother earnings
- Note: The book depreciation method does NOT directly change operating cash flow—depreciation is non-cash and is added back on the cash-flow statement, offsetting its net-income impact. What changes cash is the tax depreciation method (via cash taxes paid).
What are the assumed useful lives?
- Short lives (3-5 years) → higher depreciation → lower profits (conservative)
- Long lives (20+ years) → lower depreciation → higher profits (aggressive)
- Compare to industry peers. If Company A uses 10-year lives and peers use 5-year, question why.
What's the ratio of Accumulated Depreciation to Gross PP&E? $\text{Avg Asset Age} \approx \frac{\text{Accumulated Depreciation}}{\text{Annual Expense}}$ $Avg Asset Age \approx \frac{Accumulated Depreciation}{Annual Expense}$
- High ratio (70%+) → old assets, may need replacement capex soon
- Low ratio (20%) → recent investments, less capex pressure near-term
Is capex > depreciation? (from Cash Flow Statement)
- Yes → growing asset base, expanding
- No → milking existing assets, possibly declining

Connections

Acrual Accounting - Depreciation is a core accrual concept (expense recognition vs cash payment)
Capital Expenditures - The "purchase" side; depreciation is the "expense" side
Free Cash Flow - Operating Cash Flow minus capex (depreciation is added back inside OCF)
EBITDA - Removes depreciation/amortization to focus on operating performance
Deferred Tax Liabilities - Created by book-tax depreciation differences
Asset Impairment - When an asset's value drops below book value suddenly (not gradual depreciation)
Matching Principle - The accounting concept requiring expense-revenue matching

Recall Explain to a 12-year-old

Imagine you buy a bicycle for $100 to start a delivery business. The bike will last 5 years, then it's junk.

Should you say "I lost $100 today" even though the bike helps you earn money for 5 years? That's weird, right? It makes today look really bad and the next5 years look really good (using a bike for free!).

Depreciation is like saying: "I'm using up $20 of this bike each year." So every year, you mark down "I spent$ 20 on the bike" in your costs. After 5 years, you've written off all $100, bit by bit.

Here's the trick: **you already spent the $100** when you bought the bike. Depreciation doesn't mean you're spending$ 20 every year. It just means you're counting $20 every year as a cost, because that's fair—you're using the bike to make money that year.

When you look at your "profit," it includes this $20 cost. But when you look at your actual cash, you don't lose$ 20/year—you lost $100 on Day 1. That's why investors look at cash flow, not just profit!

#flashcards/stock-market

What is the difference between depreciation and amortization? :: Depreciation allocates the cost of tangible assets (equipment, buildings) over their useful life; amortization allocates the cost of intangible assets (patents, trademarks) over their useful life. Both are non-cash expenses.

Why is depreciation added back to net income when calculating operating cash flow?

Depreciation reduces net income but is a non-cash expense (the cash left when the asset was purchased). Adding it back removes the "fake" cash reduction and shows true cash generated from operations.

What is the straight-line depreciation formula?

Annual Depreciation = (Cost - Salvage Value) / Useful Life. This spreads the depreciable amount evenly over the years the asset is used.

If a machine costs

100,000 with

10,000 salvage value and a 9-year useful life, what is the annual straight-line depreciation?

(

100,000 -

10,000) / 9 = $10,000 per year.

What is a contra-asset account?

An account that reduces the value of a related asset account. Accumulated Depreciation is a contra-asset that reduces Property, Plant & Equipment on the balance sheet.

What is the book value (net book value) of an asset?

Original cost minus accumulated depreciation. It represents the remaining "accounting value" but NOT the market value.

Why might a company use accelerated depreciation for tax purposes but straight-line for financial reporting? :: Accelerated (MACRS) tax depreciation front-loads deductions, reducing cash taxes early and freeing up cash now. Straight-line book depreciation smooths reported earnings for shareholders.

Does the choice of BOOK depreciation method directly change operating cash flow?

No. Book depreciation is non-cash and is added back on the cash-flow statement, exactly offsetting its net-income impact. What changes cash is the TAX depreciation method, via cash taxes paid.

What is the double-declining balance (DDB) rate if the useful life is 5 years? :: Straight-line rate = 1/5 = 20%. DDB rate = 2 × 20% = 40% applied to the declining book value each year.

How is units-of-production depreciation calculated?

Depreciation per unit = (Cost - Salvage) / Total Expected Units. Then multiply by units produced in the current period. Ties expense to actual usage.

Why is goodwill not amortized under current accounting rules?

Goodwill (excess purchase price over net assets) is considered to have an indefinite useful life. Instead of amortizing, companies test it annually for impairment.

What does it mean if a company's accumulated depreciation is80% of gross PP&E?

The assets are quite old on average. The company may face significant capital expenditures soon to replace aging equipment.

What is EBITDA and why do investors use it?

Earnings Before Interest, Taxes, Depreciation, and Amortization. It approximates operating cash flow by excluding non-cash expenses and financing/tax effects, allowing comparison of operational performance.

How do you get Free Cash Flow from Operating Cash Flow?

Free Cash Flow = Operating Cash Flow - Capital Expenditures. Operating Cash Flow already has depreciation added back; FCF then subtracts capex.

What is the MACRS Year 1 percentage for 5-year property, and why isn't it 40%?

20%. MACRS uses a half-year convention (asset assumed placed in service mid-year), so Year 1 gets only half a year of depreciation; the peak 32% lands in Year 2.

What is salvage value?

The estimated resale or scrap value of an asset at the end of its useful life. Only amount above salvage value is depreciated.

True or False: Depreciation creates a cash reserve for replacing the asset.

False. Depreciation is pure accounting allocation. Cash left when the asset was purchased. No cash is set aside by recording depreciation expense.

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Dekho, idea bahut simple hai. Maan lo tumne ek delivery truck ya machine kharidi jo 10 saal chalegi. Ab agar tum poora paisa aaj hi "loss" dikha do, to galat picture banega, kyunki wo asset to aane wale 10 saal tak paisa kamane mein help karega. Isliye accounting mein matching principle kehta hai ki cost ko us time period mein spread karo jab tak asset kaam aata hai. Yahi spreading ka process depreciation (tangible cheezein jaise building, machine, vehicle) aur amortization (intangible cheezein jaise patent, software, goodwill) kehlata hai. Dono ka kaam same hai, bas asset ka type alag hai.

Ab sabse important baat jo investors ke liye samajhna zaroori hai — ye non-cash expenses hain. Matlab ye profit ko kam dikhate hain, lekin actually cash bahar nahi jaata (cash to tab gaya jab asset kharida tha). Isliye jo companies heavy assets rakhti hain (factories, equipment), unka reported profit kam dikh sakta hai, par unki asli cash-generating capacity zyada hoti hai. Agar tum sirf "low profit" dekh ke soch loge ki business kharaab hai, to galti kar rahe ho. Formula bhi seedha hai: straight-line method mein (Cost − Salvage Value) ÷ Useful Life, jisse har saal barabar expense aata hai.

Ek aur cheez — kabhi-kabhi companies accelerated methods (jaise double-declining balance) use karti hain, jahan starting years mein zyada depreciation dikhate hain. Iske do reason hain: ek to real life mein assets shuru mein tezi se value khote hain (jaise nayi car showroom se nikalte hi sasti ho jaati hai), aur doosra tax benefit — pehle zyada deduction milne se abhi kam tax dena padta hai, jo time value of money ke hisaab se faydemand hai. To bhai, jab bhi kisi company ka financial statement padho, in expenses ko dhyaan se dekhna, warna profit ki asli kahani miss kar doge.

Test yourself — Financial Statements

Connections