Depreciation and Amortization
Spreading the cost of a long-lived asset over the years it's used, rather than expensing the whole purchase price the day it's bought — the accounting fix that keeps a single big purchase from distorting one year's profit.
Prerequisites: Accrual vs Cash Accounting, Reading a Balance Sheet
If a company spends $10 million on a factory that will run for twenty years, expensing the full $10 million the year it's built would make that one year look like a disaster and every following year look artificially profitable, even though the factory is generating value the whole time. Depreciation fixes this for physical assets (buildings, machinery, equipment) by spreading the cost across the asset's useful life instead: the $10 million factory might show up as $500,000 of depreciation expense a year for twenty years under straight-line depreciation, matching the expense to the years the asset is actually helping generate revenue. Amortization is the identical idea applied to intangible assets with a defined useful life — patents, acquired customer contracts, purchased software.
The cash actually left the company all at once when the factory was built; depreciation is a purely accounting allocation of that already-spent cash across future income statements, which is exactly why it gets added back in a cash flow statement's operating section — it reduced reported profit without being a current-period cash outflow.
Different depreciation schedules (straight-line versus accelerated methods that expense more in early years) change reported profit's shape year to year without changing total cash spent, which is why analysts often look at EBITDA — earnings before interest, taxes, depreciation and amortization — to compare companies that simply made different accounting-method choices on assets that are economically similar.
Depreciation and amortization spread the cost of long-lived physical or intangible assets across their useful life instead of expensing the full cost upfront, matching expense recognition to the period the asset actually contributes value. Because the method choice changes reported profit's timing but not the underlying cash spent, D&A is added back when computing cash flow from operations and stripped out when computing EBITDA.
Further reading
- Penman, Financial Statement Analysis and Security Valuation, ch. 8