Depreciation & Amortization: Impact on Financial Statements
Understand D&A and its impact on all three financial statements. Learn the concepts, methods, and common interview questions.
Depreciation and Amortization (D&A) is a fundamental accounting concept that comes up constantly in finance interviews. Understanding how it flows through all three statements is essential.
What is Depreciation & Amortization?
Note
D&A is the systematic allocation of an asset's cost over its useful life.
Instead of expensing the full cost when you buy an asset, you spread it out over the years you'll use it.
Depreciation vs. Amortization
| Aspect | Depreciation | Amortization |
|---|---|---|
| Applies to | Tangible assets | Intangible assets |
| Examples | Buildings, equipment, vehicles | Patents, software, trademarks |
| Accumulates in | Accumulated Depreciation | Accumulated Amortization |
| Methods | Straight-line, declining balance | Usually straight-line |
Why D&A Exists
The matching principle: Expenses should be recorded in the same period as the revenue they help generate.
Example
A company buys a $1M machine that will be used for 10 years.
- Without D&A: Year 1 shows $1M expense, Years 2-10 show $0
- With D&A: Each year shows $100K expense (matching the benefit)
D&A provides a more accurate picture of profitability over time.
Depreciation Methods
Common Methods
| Term | Definition | Note |
|---|---|---|
| Straight-Line | (Cost - Salvage) / Useful Life | Most common |
| Declining Balance | Fixed % of book value each year | Accelerated |
| Units of Production | Based on actual usage | For variable-use assets |
| MACRS | Tax depreciation schedule (US) | For tax purposes |
Impact on All Three Statements
Depreciation increases by $50 this year. Assuming a 40% tax rate, what happens to cash on the balance sheet?
If D&A Increases by $100 (25% Tax Rate)
Income Statement: D&A +$100 → Pre-tax -$100 → Tax -$25 → Net Income -$75
Cash Flow Statement: Net Income -$75 + Add back D&A +$100 = Cash from ops +$25
Balance Sheet: Cash +$25, PP&E -$100, RE -$75 ✓
Key Concepts
D&A is Non-Cash
No cash leaves the company when you record depreciation. The cash left when you bought the asset. D&A is just an accounting entry to allocate that cost.
Why do we add back D&A on the Cash Flow Statement?
D&A Creates a Tax Shield
Because D&A reduces taxable income, it saves taxes. This is real cash savings: Tax Shield = D&A × Tax Rate
Book vs. Tax Depreciation
Book vs. Tax
| Term | Definition | Note |
|---|---|---|
| Book Depreciation | For financial statements (GAAP) | Usually straight-line |
| Tax Depreciation | For tax returns (MACRS) | Usually accelerated |
| Deferred Taxes | Arise from timing differences | When book ≠ tax |
A company uses accelerated depreciation for tax purposes but straight-line for book purposes. In Year 1, tax depreciation is $100K and book depreciation is $60K. What is the impact on the Balance Sheet (25% tax rate)?
Key Takeaways
Key Takeaway
- D&A allocates asset cost over useful life (matching principle)
- Depreciation = tangible, Amortization = intangible
- D&A is non-cash — add it back on Cash Flow Statement
- Tax shield: D&A saves cash through lower taxes
- Know the three-statement impact — it's a classic interview question
Continue Learning
- How the 3 Financial Statements Link — Master the full flow
- Cash Flow Statement Explained — Deep dive on cash flows
- Enterprise Value vs Equity Value — Core valuation concept