Understanding Depreciation and Amortization

What is Depreciation?

Depreciation is the reduction in the value of an asset over time, often due to wear and tear. It is an important concept in financial arithmetic as it helps in understanding how the value of assets decreases annually.

Key Points:

• Depreciation is typically calculated annually.
• It affects the book value of assets.
• Common methods include straight-line and reducing balance methods.

What is Amortization?

Amortization is similar to depreciation but is used for intangible assets. It refers to the gradual reduction of an intangible asset's value or the repayment of a loan over time.

Key Points:

• Amortization applies to intangible assets like patents and copyrights.
• It also refers to the spreading of loan payments over time.

Calculating Depreciation Using the Straight-Line Method

The straight-line method is the simplest way to calculate depreciation. It involves spreading the cost of the asset evenly over its useful life.

Formula:

$$\text{Annual Depreciation} = \frac{\text{Cost of Asset} - \text{Salvage Value}}{\text{Useful Life}}$$

Calculating Depreciation Using the Reducing Balance Method

This method calculates depreciation based on a fixed percentage of the asset's book value at the beginning of each year.

Formula:

$$\text{Depreciation for Year} = \text{Book Value at Start of Year} \times \text{Depreciation Rate}$$

Examples

Example 1: Straight-Line Depreciation

A company buys a computer for $2,500. It has a salvage value of $500 and a useful life of 4 years. Calculate the annual depreciation.

Solution:

• $$\text{Annual Depreciation} = \frac{2,500 - 500}{4} = \frac{2,000}{4} = 500$$
• The annual depreciation is $500.

Example 2: Reducing Balance Depreciation

A machine is purchased for $8,000 with a depreciation rate of 15%. Calculate the depreciation for the first year.

Solution:

• $$\text{Depreciation for Year 1} = 8,000 \times 0.15 = 1,200$$
• The first year's depreciation is $1,200.