Depreciation is a prime example of what accountants call a non-cash expense[1]. Right here, of course, is where they often lose the rest of us. How can an expense be other than cash? The key to that puzzling term is to remember that the cash has probably already been paid. The company already bought the truck. But the expense wasn’t recorded that month, so it has to be recorded over the truck’s life, a little at a time. No more money is going out the door; rather, it’s just the accountant’s way of figuring that this month’s revenues depend on using that truck, so the income statement better have something in it that reflects the truck’s cost. Incidentally, you should know that there are many methods to determine how to depreciate an asset. You don’t need to know what they are; you can leave that to the accountants. All you need to know is whether the use of the asset is matched appropriately to the revenue it is bringing in.
Amortisation is the same basic idea as depreciation, but it applies to intangible assets. These days, intangibles are often a big part of companies’ balance sheets. Items such as patents, copyrights, and goodwill (to be discussed further in a later lesson) are all assets – they cost money to acquire, and they have value – but they aren’t physical assets like real estate and equipment. Still, they must be accounted for in a similar way. Take a patent. Your company had to buy the patent, or it had to do the research and development that lies behind it and then apply for it. Now the patent is helping to bring in revenue. So, the company must match the expense of the patent with the revenue it helps bring in, a little bit at a time. When an asset is intangible, though, accountants call that process amortisation rather than depreciation. I’m not sure why – but whatever the reason, it’s a source of confusion.
[1] A non-cash expense is one that is charged to a period on the income statement but is not actually paid out in cash. An example is depreciation: accountants deduct a certain amount each month for depreciation of equipment, but the company isn’t obliged to pay out that amount, because the equipment was acquired in a previous period.
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