Finance/Accounting 101: Amortization and depreciation

The Matching Principle (accounting): Expenses are matched to and recorded in the period where you have realized the benefits (Accounting Coach, n.d.).  It doesn’t matter when you received or sent an invoice out, it matters only when you get paid or you pay the invoice (Apptio, 2018).  In other words, I get my credit card statement on the 23rd of the month (a weird date, but it is what it is).  The credit card company cannot realize the benefit/payment of the invoice until I pay it, therefore it is a liability for them (Accounting Coach, n.d.).  Usually, people have about a month or less to pay back their balance in part or in full.  Until I decide to pay them the credit card company cannot account for the money, which means the credit card company cannot say it is Revenue (Accounting Coach, n.d., Apptio, 2018).  This is because, how can the credit card company say I paid them for the service rendered if I haven’t cut the check or e-paid my bill? However, when I do pay, I can pay it on the 23rd, 24th or the 2nd of the month. Once I pay my bill, either in part or the full amount, the credit card company can say they realized the benefits for the service rendered (in this case, me borrowing money on credit).

Depreciation and Amortization (accounting/finance): This refers to how money is spread throughout the lifetime of the product or service (Apptio, 2018).  The best example we have for amortization is a mortgage on a house.  When I bought my house, I got a long printout (excel sheet style and a waste of trees) of how much I will be paying for my mortgage, how much of that will go to escrow, how much of that will go to the principle and how much of that goes to the interest.  The mortgage schedule shows that over time I will pay more into my principle and less into the interest, which tends to lower the book value of my housing loan (Investopedia n.d.a.).   If I were to sell the house, and it losses value during a housing bubble, then I will be in a budget shock (Apptio, 2018). The reason is that the entire amortization schedule is due in full at the date of closing, and I will be on the hook for the difference.

So, let’s look into buying a new car! When we buy a shiny new car and drive it off the lot, it is said to depreciate over 20% in a matter of seconds.  Over the course of the first two years, the cost of the car will further depreciate, therefore the best advice usually is to wait 2-5 years after the car has been manufactured to keep most of your money, given that the most depreciation occurs in the first 2-5 years (2 Cents, 2018).  Thus, depreciation is not necessarily the loss of intrinsic value for car usage, just a loss of financial value over time (Apptio, 2018).  Depreciation is accounted for in taxes or in accounting books, it can be used to illustrate the loss of value of an asset over the life of the asset (Apptio, 2018; Investopedia, n.d.b.).

Note that in business, assets can be tangible, usually a physical server, a building, etc., or intangible, like patents or copywrites, etc. (Apptio 2018).

Resources:

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