Why is depreciation/amortization considered a non-cash transaction

I don’t really get that…can anyone shed some light?

Because no physical exchange of money occurs. Think about it: assets are “consumed” in the production process, and you need to expense the cost using these equipments in the cost of the products you produce – this is what depreciation is. But since you do not physically consume the resource, the asset, as it would be when you consume inventory, instead of having a replacement cost you have depreciation

Thanks for your reply map1. This helps a little bit. I guess now the hard part is just remembering all of the factors that tie into the expense being non-cash.

>> This helps a little bit. I guess now the hard part is just remembering all >> of the factors that tie into the expense being non-cash. As much as I am bored and worn out by the tedium of Financial Statement Analysis reading, this part is actually very easy. You need to make sure you know what depreciation and amortization are: Depreciation - Let’s say you bought a machine for $1000 whose life span is 10 years and let’s pretend the its value decreases $100 per year until it’s worthless at the end of the 10 years. On the day you bought the machine, you record a $1000 decrease in cash and $1000 increase in “Machine Asset”. What happens in a year? According to your books thus far, you still have $1000 machine asset, but the reality is your machine is worth only $900 now so you’re overstating your assets. So you enter a “depreciation expense” for $100 to reflect the decrease of the machine’s value. Now the combined value of “Machine Asset” and “Machine Depreciation” is $900 so your assets are valued properly. Once you understand this, it becomes clear that entering the depreciation expense is no different than erasing the $1000 and replacing it with $900. No cash exchanges hands. Therefore it’s not a cash transaction. Amortization - Let’s imagine you’re buying the same machine: it’s worth $1000 and you plan to use it for 10 years. Let’s say you pay the entire $1000 for it at the time the machine is obtained. Let’s say that ignoring the purchase of the machine, you expect to record $500 of income each of the next 10 years. How to record the purchase of the machine? You could count it as an expense in the first year, which means your income for that year is -500 and then 500 for each of the subsequent 9 years. Or you can recognize that since the benefit of the machine is going to be accrued over the next 10 years, you should also expense it over the next 10 years. So you might expense $100 of the machine each year and thus have 10 years of $400 income. The thing to notice is, again, that the choice of amortization impacts the accounting numbers for your expense and income, but it does NOT alter the fact that the actual CASH was paid out on day one. Since amortization does not affect cash, it is not a cash transaction. I would imagine that choice of amortization and depreciation DO end up affecting your cash flows as they affect your income figures and thus the amount of tax due, but the actual transactions themselves do not involve the exchange of cash. Hope this helps / is correct / makes sense.

Ed, Amortization and depreciation are not the same things. Depreciation refers to physical assets, while amortization refers to intangible assets (such as goodwill). Basically, the idea behind these two accounting charges is the same, but they can’t be used interchangeably. Milos

I agree with what Milo syas that Depreciation is for Physical assets and Amortization is for Intangible assets. Intangible could mean any Non physical assets. Now the question - For Premium bonds - Premium is amortized over the maturity period. For Discount Bonds - Discount is amortized over the maturity period. Is the premium or discount that is amortized an intangible asset? Amortization of these - increase or decrease the Interest Exp. Or is the interest Exp an intagible asset? Well Expense cannot be an asset - so could it be premium n discount which are intangible assets?

When you amortize Premium / Discount --> the Amortization Expense shows up on the Income Statement, in addition to the Depreciation Expense for the Period. Interest expense would also show up on the Income statement. All of these go towards reducing the Net Income. If you had a bond which was a Premium bond and another which was a Discount bond, the net Amortization expense would be shown. This Amortization Expense would be the difference between the Interest calculation on the Liability value and the Coupon Payment on the Face value. For a Discount bond – this would be a Positive number. For a Premium bond this would be a negative number, and both would be netted. When you created the Bond – you had a Intangible Liability – Bond Payable that got created. You would also have an intangible Asset Bond Premium or Bond Discount that gets created. And the Cash was the other side. So e.g. for a Discount bond bought at 90, the accounting entries would be: Discount Bond: ======================== DR Cash 900 DR Bond Discount 100 ******CR Bond Payable 1000 Premium Bond @ 110 DR Cash 1100 ****CR Bond Payable 1000 ****CR Bond Premium 100 It is the Bond Premium and Bond Discount (Intangible Assets) which are being amortized. Hope this helps. CP

Thanks CP that clarifies it a lot. BTW what does DR & CR stand for ? Thanks in advance. Amit

DR = Debit CR = Credit This is the T-Account set up. CP

I would avoid characterizing premium and discount as intangibles. They are contra accounts to things like bonds, and are components of financial assets.

Thanks Super. I was not sure of the characterization with respect to the tangible portion of it. However, since Amortization applied to intangibles - I went with that definition.