Depreciation and amortization

Depreciation and amortization is an accounting method under which the cost of a long-lived asset is not expensed in full at the moment of purchase but is instead spread across the periods in which the asset is in use. A machine tool is paid for one time, yet it generates revenue for years, so the financial statements stretch the expense over its entire service life, allowing each year's profit to be matched against what that year actually consumed.

How the cost is allocated

The company determines the asset's useful life and its residual value — what will be left of it at the end. The difference between the original cost and the residual value is spread over that life: in equal portions under the straight-line method, in proportion to output under the units-of-production method, and faster in the early years of the asset's life under accelerated methods. For buildings and equipment this is depreciation of property, plant and equipment; for intangible assets it is the amortization of licences, patents and capitalised development costs; for leased items it is amortization of the right-of-use asset. On the balance sheet, the amount charged over all the years accumulates and is deducted from the original cost, leaving the carrying amount. No cash reserve is created in the process: the money left the company earlier, at the time of capital expenditure, and depreciation and amortization merely record that outlay in the income statement.

An example using the site's data

The more asset-heavy a company is, the more noticeably depreciation and amortization weigh on its profit — and the more readily investors turn to a measure that adds them back. For Nornickel, earnings before interest, taxes, depreciation and amortization currently stand as follows: EBITDA — no data.

What it is confused with

The main mix-up comes from the same word being used for bonds: bond amortization means that the issuer repays the face value in instalments, and these are real payments to the holder, not an accounting entry. The second confusion is with impairment: depreciation and amortization follow a schedule and say nothing about whether the asset has gained or lost value, whereas an unscheduled write-down to the recoverable amount is the work of asset impairment. The third is reading EBITDA as free cash: depreciation and amortization are added back into it arithmetically, but worn-out equipment will still have to be replaced, and that is a matter for investing cash flow.