Financial Dictionary - Depreciation and amortisation
Depreciation and amortisation
Depreciation and amortisation are economic and accounting terms, linked to the process that exists between the expense or depreciation of an asset, over a period of time.
The depreciation or amortisation of an asset is directly related to the goods and services: a house, a motorbike, a boat, a household appliance, etc. While the amortisation of a liability is related to the financing provided by a creditor and represents what the person or a company owes to third parties. A very common example has to do with loans we obtain from banks, payments to suppliers, taxes, salaries, etc.
The depreciation and amortisation of both assets and liabilities involves spreading an amount of money that has been or is to be paid over a series of fixed periods.
Types of depreciation and amortisation
The type of depreciation or amortisation used depends on the type of asset or liability involved. Here we will explain what they are with an example:
- Depreciation of tangible assets
In this case, we could talk about depreciation as the division of the value of an asset by its useful life. Let's look at this concept in an example:
You just bought a TV worth €2,000. We could calculate that the useful life or the period of obsolescence of a television is usually around 10 years.
OK, so if that television is going to last us 10 years and we have paid €2,000 for it, we can say that every year we will be paying €200 for it, even if we paid for it in full when we originally bought it.
The spreading of the value of the good over the years of its useful life is what we call depreciation of tangible assets. In other words, every year €200 of the total value of the television is written off.
A very useful trick for this type of depreciation, thinking ahead to when the asset's useful life comes to an end, would be as follows:
You just bought a television worth €2,000. OK, so if we know that the period of obsolescence of this product is 10 years and that each year we would be writing off €200, the best thing to do would be to save the amount of this “depreciation value” in a deposit account every year, so that after 10 years, you can buy a new TV and not have to take the financial hit of suddenly having to find the money to pay for it. This saving technique is known as technical or economic depreciation.
- Amortisation of an investment
This type of amortisation occurs when an asset stops costing us money and starts to provides us with a benefit. In other words, an investment is considered amortised when it has covered its own cost by providing us with the same amount of benefits.
A simple example could be your gym membership fee. If the monthly fee involves an "investment" of €50 and each month you only exercise on 7 days, each of those days has cost you around €12. However, if you go to the gym every day, each of these workouts will cost you €1.66. That is what it is all about, knowing how much you need to use an asset to make it a good investment.
- Amortisation of a debt
This is the most popular amortisation model in the financial world. A debt, as it is well defined, is money that you owe to a person or a financial institution for a specified period of time. Amortisation, in this case, refers to the repayment of that debt, which, in general, is made over fixed or variable periods depending on the agreement that has been reached when making the loan or credit official. The interest rate stipulated in each instalment is also included in debt amortisation.
A simple example of the repayment of a debt could be the following:
You decide to buy a television for a value of €2,000 and, to pay it, you ask a financial institution for a loan or credit. You decide to finance the television for a term of 24 months and at 0% interest. In this case, the repayment plan would be for €83.33 (€2,000/24) over each of the next 24 months. At the end of the 24 months you will have fully amortised the appliance. Where interest is payable, that percentage rate must be applied to each of the instalments and you will see it reflected in the repayment plan.