How to Differentiate Depreciation from Amortization and Depletion
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How to Differentiate Depreciation from Amortization and Depletion

In Financial Accounting, Depreciation, Amortization and Depletion have one major purpose, that is, to allocate the cost of an asset over its useful life. However, how does one differentiate Depreciation from Amortization and Depletion when they have the same major purpose? They generally differ on the category of asset to which they belong.

Depreciation, Amortization and Depletion are created in order to follow one of the basic principles in Financial Accounting which is matching principle. Matching Principle in Financial Accounting mandates that expenses should be matched and incurred when revenue is realized. Thus, Assets with future useful life should not be expensed outright, rather allocate the expenses over the useful life of the Asset. The accounting terms, Depreciation, Amortization and Depletion should not be used interchangeably because they have different classifications according to which category of asset they should belong.

Depreciation Expense is an accounting term used as Account Charged for the Depreciation of Fixed Assets such as Property, Plant & Equipment, Tools & Small Equipment and Furniture & Fixtures. Over the years, Accounting Standards are developed by each company as to when an expenditure be capitalized and when it should be an outright Expense in order to be consistent. The creation of lower limit in the Capital Expenditure is implemented in order to identify that such acquisition should be classified as Fixed Asset and Depreciation Expense should be recognized accordingly.

There are various methods in determining the depreciation of Fixed Assets. The most common method is the Straight Line method of Depreciation:

Depreciation = Cost of Fixed Asset – Salvage Value / Useful Life

Amortization Expense on the other hand, is an accounting term used as Account Charged for the Amortization or allocation of Expenses for Prepayments & Intangible Assets. Prepayments or Prepaid Expenses include Premiums, Insurance or Rents. Prepaid Expenses are classified as Current Assets because these are short-term assets and they will be amortized over a year or less after the balance sheet date. Amortization of Prepaid Expenses is calculated according to the term of payments.

Intangible Assets include trade names, trademarks, franchise licenses, patent, copyrights, government licenses, goodwill and other assets that lack physical substance but provide long-term benefits to the company. Amortization for Intangible Assets is allocated over the useful life or legal life, whichever is shorter, but not to exceed 40 years.

Depletion is an accounting term used to identify the depreciation of wasting assets or natural resources such as mines, oil wells, timber trees and others over its useful life.

Depletion is computed using the cost method or the percentage method. Cost method in depletion is simply allocating the costs of the natural resource over the period that make up the life of the asset. This is done by assigning the proportionate cost of the quantity extracted on that certain period. Percentage Method of Depletion is derived by assigning a certain percentage for each natural resource or wasting asset and multiplying the rate by the gross income of that property.

Cost method of Depletion:

Depletion = Total Cost x Quantity Extracted for the Period / Expected Total Quantity to be Extracted

Percentage Method of Depletion:

Depletion = Depletion Rate of the Natural Resource X Gross Income of the Resource.

Depreciation, Amortization and Depletion have the same concepts in general in Financial Accounting. These accounting terms are not only useful for profit maximization since Depreciation, Amortization and Depletion Expenses are allocated over a specified period, but also to enhance proper Expense Recognition and Balance Sheet Classification of Assets.

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Comments (2)

Welcome aboard the Good Ship Knolji, Jeanette. Sorry for the confusion. One of the things that we are hoping to eliminate with our new site design is such unnecessary confusion. Finance is not one of my fortes but if I can help you in any way as you strive for success here on knolji, please feel free to send me your questions. I am the guide/Moderator for the DIY channel, but you can find my interests run the gamut as do the type of articles I write.

Once again, nice to have you with us.

Thanks for your recommendation, Sir Jerry. I was just wondering if what you mean when you say, "confusion". Please let me know if I need to improve other aspects of my articles. It's so nice to hear from you. =)

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