One of the fundamental accounting principles is matching concept. This principle requires that expenditures should be charged in the same accounting period in which the corresponding revenues are recognized. This principle is important to ensure accurate reporting of income and expenses. Fixed assets, both tangible and intangible though purchased in one accounting period, there benefit may accrue to the entity across several accounting periods. Therefore, in accordance with the matching concept, their cost is to be allocated across the time period for which its revenue accrues.
This article looks at meaning of and differences between two such asset cost allocations – amortization and depletion.
Definitions and meanings
Amortization:
Amortization is the allocation of the acquisition cost of an intangible asset across its useful life. Amortization applies to intangible assets such as patents, trademarks, copyrights etc. These assets generally have a specified life which is known at the time of their acquisition. Their cost is allocated across this time period on a straight-line basis and this allocated cost is charged to the profit and loss account each year as an expense.
The formula for amortization:
Total cost of the intangible asset/Useful life in years
An example:
M/s ABC Inc is a pharmaceutical company that has acquired a patent for one of its formulations. The patent cost amounts to $1,00,000 and the patent has been awarded for 20 years. The entire patent cost would be capitalized in Year 1 and each year an amount of $5,000 (1,00,000/20) would be amortized to the profit and loss account as an expense.
The accounting journal entries for the above example are as follows:
Year 1
Intangible asset a/c ………………. Dr 1,00,000
To Bank a/c …………………………………….1,00,000
(Being patent cost capitalized in the books)
Year 1
Amortization a/c………………………. Dr 5,000
To accumulated amortization on intangible asset a/c ……. 5,000
(Being cost of patent amortized to the P&L a/c)
Year 2 to 20
Same entry to be passed for each of next years till Year 20
The life over which the cost of the intangible asset is to be amortized is generally found in an agreement or related documentation prepared at the time of acquisition of the asset.
Depletion:
Depletion is the reduction in the value of a natural resource as its supply is periodically exhausted on extraction. Natural resources such as coal, minerals, oil have to be mined or extracted to be utilized. Companies incur significant costs to extract these natural resources. However, these natural resources are not in unlimited supply and have a specific capacity. The allocation of this cost of extraction across the number of units that can be extracted is depletion.
The formula for calculating depletion:
Cost – salvage value/No. of units that can be extracted
An example:
A coal mining company has spent $5,00,000 on exploring and purchasing a coal mine. It is expected that the coal mine will produce 10,000 tons of coal and the mine is expected to fetch a salvage value of $20,000. The cost of $5,00,000 will be capitalized in the books and the amount of depletion will be calculated as follows
= (4,80,000/10,000)
= $48 per ton.
This amount will be charged to profit and loss account each year depending on how many tons of coal are extracted in that year.
The accounting journal entries for the above example are as follows:
Year 1:
Tangible asset a/c ………………. Dr 5,00,000
To Bank a/c …………………………………….5,00,000
(Being cost of developing mine capitalized in the books)
Year 1:
500 tons extracted in Year 1 (500 × 48 = 24,000)
Depletion a/c……………………………. Dr 24,000
To accumulated depletion a/c …………24,000
(Being cost depletion charged to the P&L a/c)
Year 2:
1000 tons extracted in Year 2 (1000 × 48 = 48,000)
Depletion a/c……………………………. Dr 48,000
To accumulated depletion a/c ………… 48,000
(Being cost depletion charged to the P&L a/c)
This will continue till 10,000 tons of supply of the coal mine is exhausted
Difference between amortization and depletion:
The difference between amortization and depletion have been detailed below:
1. Meaning
- Amortization is a systematic allocation of cost of an intangible asset across its useful life.
- Depletion is the reduction in the value of a natural resource as its supply is extracted and utilized.
2. Assets to which it is applicable
- Amortization is applicable to various types of intangible assets such as licenses, patents, trademarks, trade names, copyrights etc.
- Depletion is applicable to tangible assets that are natural resources such as coal mines, oil fields, mineral reserves etc.
3. Applicability to industry type
- Amortization is applicable across a wide range of industries – primarily any industry that has developed or purchased an intangible asset.
- Depletion is applicable to a narrower range of industries – only being applicable to entities engaged in exploration and extraction of natural resources.
4. Reason for charge
- Amortization is charged due to limited legal and economic life that intangibles may have.
- Depletion is charged due to likelihood of exhaustion of supply of natural resources.
5. Basis for charge
- The basis for charge of amortization is useful life in number of years, typically determined with reference to terms of agreement of acquiring the intangibles.
- The basis for charge of depletion is number of units that can be extracted, typically determined based on an assessment of the capacity of the natural resource.
6. Consideration of salvage value
- Intangibles generally do not have any salvage value – i.e.: any value that can accrue at the end of its useful life. Hence this is not considered in the calculation formula.
- Natural resources such as coal mines, oil fields etc. can have a salvage value that the entity may be able to receive even after exhaustion of its supply. Hence salvage value is estimated and considered in the calculation formula.
7. Value of year on year charge
- Amortization is generally charged on a straight-line method i.e., the charge to profit and loss remains the same for each year of its useful life.
- Depletion is charged on the basis of the supply extracted each year. Thus, the charge to profit and loss can change each year.
Conclusion:
Both amortization and depletion, are non-cash expenses that are charged to the profit and loss account on a year on year basis. As these expenses generally relate to high value fixed assets, their correct determination and reporting is necessary to reflect accurate financial health. Across jurisdictions, several accounting standards and rules have been formulated to ensure appropriate charge of these expenses.
