Depreciation, Depletion, and Amortization - Explained
What is Depreciation Depletion and Amortization?
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Table of ContentsWhat is Depreciation, Depletion, and Amortization?What is Depreciation?What is Depreciable Property?Examples of Depreciable PropertyWhat is Accumulated DepreciationUsing the Accumulated Depreciation MethodDepreciation and TaxesDepreciation MethodsWhat is Amortization?Amortization versus DepreciationExample of Amortization an AssetWhat is Accumulated AmortizationWhat is Depletion?Methods of DepletionPercentage Depletion MethodCost Depletion MethodDepletion BaseDepletion Reporting Requirements
What is Depreciation, Depletion, and Amortization?
Depreciation, depletion, and amortization (DD&A) refer to an accounting technique (generally accrual accounting) that a company uses to match the cost of an asset to the revenue generated by the asset over its economic useful life.
When DD&A is used, it allows a company to spread the expenses of acquiring a fixed asset over its useful years. While depreciation is applicable to tangible assets, otherwise called long-term assets, amortization is applicable to intangible assets.
Depletion, on the other hand, is used for natural resources such as oil and gas and other natural extracts, this allows the expenses incurred while exploring and extracting the natural resources to be allocated or spread over the exhaustion or consumption of the natural resource.
Back to: ACCOUNTING, TAX, & REPORTING
What is Depreciation?
The value of various types of asset decreases over the years for various reasons. This is known as depreciation. The depreciation method is used for measuring that decrease. This accounting method allocates cost to a tangible asset over its useful lifespan. It is used for tax and accounting purposes.
Depreciation is a measured conversion of the cost of an asset into an operational expense. Depreciation affects the net income reported and balance sheet of a company.
What is Depreciable Property?
Depreciable property is otherwise known as a depreciable asset, this is an asset that can be depreciated following the Internal Revenue Service (IRS) rules. When depreciated, the value of the asset is regarded as business expenses over its useful life, this is deducted from the tax return of the business.
There are certain requirements that property or asset must meet before it qualifies as depreciable property. These requirements are states in Publication 946 of the IRS rule, they are;
- The property must be used in business and give productive outputs,
- The property must be owned by the individual,
- The property must have a fixed useful life which must be over a period of one year.
Long-term assets and certain intangible properties qualify as depreciable property. For intangible property such as patents and copyrights, they are amortized rather than depreciated
Examples of Depreciable Property
Depreciable properties or assets include:
- Landed properties
- Business facility
- Machinery automobiles (trucks and vehicles)
- Office equipment such as a computer, scanner, projector, and others.
It is important to know that land is not a depreciable property but landed properties such as buildings, warehouses, storage facilities, and other constructions are depreciable properties.
What is Accumulated Depreciation
Accumulated Depreciation is the entire portion of the cost of an asset allocated to depreciation expense since the time an asset is put into service.
It is an account in which the declining value of the asset accumulates as time passes until the asset is fully depreciated, removed from the inventory list, or sold.
The account created for accumulated depreciation is a compensatory one which decreases the fixed assets account. Unlike other accounts, this one continues to increase until after the asset has been written off, sold, or fully depreciated. It is therefore not closed at the end of the accounting period.
When an asset is purchased, the average useful life (period in which it will be used in business) is calculated. Then the annual or monthly depreciation amount is determined using depreciation methods. The cumulative depreciation value must be in tandem with the original price of the asset.
Using the Accumulated Depreciation Method
This method involves the calculation of the annual amount by which the asset is depreciated and then making subsequent summation until the amount corresponds to the original of the depreciated asset.
Each asset has a determined useful lifespan. Even if you do not use the asset, a measure of annual depreciation for that asset will still be recorded for accounting purposes in recognized depreciation tables.
A debit for depreciation expenses and credit for accrued depreciation are recorded every month in the general ledger. Debit depreciation expenses represent the margin of the net income while accrued credit depreciation serves to control a balanced account.
The depreciation class includes an asset account which appears as an asset in the balance sheet, and therefore it maintains a positive balance. This depreciation class is under assets subject to depreciation, and it shows in the balance sheet as the net depreciable asset together with the depreciation sum account.
The difference in the balance of this type of depreciation and the depreciation expense of a depreciable asset is because the second one shows the depreciation for the period while the first one shows all the depreciation amount calculated since the company acquired the asset.
Depreciation and Taxes
The cost of the long-term, tangible assets can be deducted as business expenditures (expense), which in turn reduces the taxable income.
In order to secure the tax deduction, a company must follow the IRS rules while depreciating their assets. The IRS has fixed rules on how and when a company can claim such deductions.
Depreciation does not involve any real cash flow. The value of an asset decreases due to a number of reasons including wear and tear or obsolescence. Different countries have different laws and regulations for calculating depreciation.
The calculation method of depreciation and the time period for depreciation may vary from one asset to another within the same company. The methods employed under the US tax code include:
- Fixed percentage - The company can deduct a fixed percentage of the value of the asset each year.
- Straight line - This means that a fixed amount is allowed to be deducted each year.
- Declining balance - This allows for deduction of a percentage of the specific method that changes each year.
What is Amortization?
In accounting, amortization refers to a method used to reduce the cost value of a intangible assets through increments scheduled throughout the life of the asset.
In other contexts, Amortization also refers to loan repayment over time in regular installments of principal and interest satisfactorily, to repay the loan in its entirety as it matures.
Deducting capital expenses over an assets useful life is an example of amortization, which measures the use of an intangible assets value, such as copyright, patent, or goodwill.
Amortization is carried out to the following assets or liabilities:
- Deferred charges
- Prepaid expenses
- Intangible Assets
There are many qualifying intangible assets, but the most popular ones include:
- noncompetitive agreements as they relate to business acquisitions
- franchise and trade names
- value of acquired knowledge for a worker
- a business human capital or quantified economic value of workers skills
Amortization versus Depreciation
There is a fundamental difference between amortization and depreciation.
Depreciation typically relates to tangible assets, like equipment, machinery, and buildings. Amortization, however, involves intangible assets, such as patents, copyrights, and capitalized costs.
With liabilities, amortization often gets applied to deferred revenue, such as cash payments usually received before delivery of services or goods. Its income earned over a future length of time.
Amortization is the way accountants assign the period concept in financial statements based on accrual. For example, expenses and income get recorded in the period concerned instead of when the money changes hands. You wouldn't charge the whole cost of a new building in the acquisition year because the life of the asset would extend many years.
Even with intangible goods, you wouldn't want to expense the cost a patent the very first year since it offers benefit to the business for years to come. Thats why the costs of gaining assets throughout the years are significant because the company can continue to use it or create revenue from it.
There is no set length of time am intangible asset can amortize it could be for a few years to 30 years. The value of an asset should decrease throughout its useful life.
Example of Amortization an Asset
A company purchases the patent on a machine for 30,000 dollars. The useful life of the patent for accounting purposes is deemed to be 5 years. So, the asset is amortized at 20% per year or 6,000 dollars per year. The accumulated amortization is the total value of the asset amortized since it was acquired.
Let's use another example. A moving company uses a $50,000 truck to move property from one place to another, and the vehicle has a useful life of 10 years. On a straight-line basis, the annual depreciation expense is the $50,000 cost divided by 10 years, which is $5,000 each year. Now if the asset to be accounted for is a trademark a company pays $200,000 to keep exclusive intellectual property rights for 40 years, the corporation will post a $5,000 of amortization expense over the 40 years. The trademark and the truck both help to generate profit and revenue for their respective business over a specific length of time.
What is Accumulated Amortization
In accounting, accumulated amortization refers to the sum allocated to an asset from when it started being used to the period it was quantified. The allocation of sum or cost is done periodically.
Accumulate amortization in both accounting and tax might have the same sum of have different sums. This is based on certain factors such as when depreciations are yet to be deducted from tax expense.
The beginning of accumulated tax depreciation, as well as deferred tax depreciation, is estimated based on the following rules;
- The date when intangible assets are acquired is the start of amortization for these assets.
- Tangible assets begin amortization on their date of entry. In some cases, the date of entry into operation might also be the date it was acquired, while in other cases, it is not.
- Financial fixed assets cannot be amortized, their losses can however be transferred.
Depreciation can be accounted for annually, represented as cumulative fiscal depreciation, in some cases, it can be quarterly, monthly, and so on.
What is Depletion?
Depletion refers to an accrual accounting technique commonly used in the natural resources extracting industries such as mining, petroleum, timber, among others.
What makes depletion similar to depreciation is that they are both cost recovery system for tax reporting and accounting. The depletion deduction enables an individual to account for the product reserves reduction.
After capitalizing natural resource extraction costs, you can easily allocate the expenses across different periods based on the extracted resource. Until that time, when the expense recognition takes place, these costs are usually held on the balance sheet.
Methods of Depletion
There are two methods of depletion used for the purpose of tax. They include cost and percentage.
Percentage Depletion Method
Percentage technique is one of the many methods used to calculate expenses related to depletion. It works by assigning a fixed percentage to gross income to allocate expenses. This method requires heavy use of estimates. For this reason, it is not relied upon.
Cost Depletion Method
Cost depletion is also another method of calculating depletion. It is an accounting technique where you allocate the costs of natural resources to depletion over the period making up the assets life. To calculate cost depletion, you take the property basis, units total recoverable, and accounts number of units sold. As you extract natural resources, they are counted and removed from the basis of the property.
Depletion base refers to capitalized costs that are depleted across a number of accounting periods. We have four types of depletion base costs:
- Acquisition costs to lease or purchase the property
- Location and exploration of expenses
- Costs for preparing the property for the extraction of natural resources
- Costs to do with the restoration of property to its condition
Depletion Reporting Requirements
The Internal Revenue Service (IRS) rule requires that you use the cost method when dealing with timber. You are also supposed to use a method that produces the highest deduction when dealing with mineral property.
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