In accounting, depreciation and amortization allow companies to expense large purchases over time, rather than showing them in one period on the income statement, which would produce a large drop in earnings. Additionally, depreciation and amortization reflect the "using up" of assets over time and tell investors and analysts information about the age of the company's remaining assets and the amount of money spent acquiring new assets.
1. Determine which depreciation method the firm uses to depreciate its assets. For book accounting purposes, this is usually straight-line depreciation.
2. Determine the depreciable lives of each of the depreciable assets. Unless an asset was just purchased, the balance sheet and income statement will reflect the amount of depreciation that has been recorded and accumulated so far. If necessary, divide an asset's original cost by the amount of depreciation expensed for that asset in a one-month or one-year period to figure out the asset's total and remaining useful life.
3. Calculate the amount of depreciation for the current period. Using a straight-line depreciation example, suppose a machine costs a firm $1,000 and, according to the IRS rules, has a depreciable life of seven years. The $1,000 cost is divided by seven, resulting in the amount of yearly depreciation that is transferred over to the income statement and shown as an expense. Many firms prefer to book depreciation expenses each month.
4. Look on the company's balance sheet for assets of an intangible nature. Depreciation records the value being used up over time for tangible assets; amortization serves the same purpose for intangible assets such as trademarks, patents or goodwill the company has acquired.
5. Calculate the amortization amount for the given period using straight-line amortization. You will need to know the intangible asset's original book value and useful life. The IRS generally allows a 15-year amortization unless legal requirements provide for a different time frame. For example, certain assets, such as franchise rights, can be amortized over the maximum allowable time frame of 40 years, while most patents have a 17-year life.
6. Record the amounts of amortization and depreciation expense that apply to the current accounting period. These amounts will show as expense items on the income statement.
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