Assets, depreciation and amortization: what are they?
As an entrepreneur, you will often hear about several economic concepts, even if you don’t manage your business accounts personally. It would be advisable to know what these concepts mean, so that you may make the required decisions knowing what they will actually involve.
What is an asset?
An asset is an element that belongs to the company; these could be goods, rights, or any other resources. This is to be exploited to obtain an output that provides benefits for the company.
There are many different assets, ranging from the computer you manage your company with to the right of exclusively exploiting a brand in a given area.
What kinds of assets are there?
Assets may be divided into two main categories according to their continuity or “useful life”:
These are permanent resources that remain in the company for a long period of time (more than 3 years). No plans are made (at least in day-to-day company decisions) to get rid of them.
Several examples of active assets are the premises or buildings that belong to the company, or the van used to deliver products.
Fixed assets may also be called immobilized assets or non-current assets. All these definitions describe the same concept.
These are the elements that belong to the society but are to be used or passed on in the daily activity of the company. They usually remain in the company for a short term (usually less than a year).
Those assets are usually included in the action process of the society. Let’s take a bakery as an example: flour is a current asset, because even though it is available and is just another resource that belongs to the company, it will be used in the production process in a relatively short time.
Flour will be used, for instance, to make bread, so that it will be transformed and sold and will no longer belong to the society. Further on, more flour will be bought, along with other raw materials, in order to carry on the production and ordinary activity of the company, which in this case involves baking bread.
As was the case with fixed assets, current assets may be given different names, such as non-capital assets or non-current assets. All the aforementioned definitions describe the same assets.
Are all assets in a company worth the same permanently? What is depreciation?
No, they don’t. Assets, as well as any other rights or resources, undergo value changes depending on several circumstances. Such circumstances may be related to the resource itself (internal) or else to its surroundings. Reductions in value suffered by assets are called depreciation.
Thus, for instance, exploitation rights for a mobile communications business won’t be worth the same if only one network is given the permission to work with the 4G network or else if more than 10 licenses have been granted to work on the 4G network.
The more competitors are in it, the less worthy the resource becomes, as competition reduces its exploitaiton prices.
On the other hand, from an internal point of view, assets also depreciate “on their own”; for instance, they become less worthy as time goes by. Thus, a desktop computer with a Windows 98 operating system could be worth 10 times as much when it was launched into the market than it is worth now.
This is due to time, to the wear and tear associated to use, and to the advances in technology that make it less worthy than it was before.
The same could be said regarding equipment in a factory, motor vehicles in a company, delivery vans or even intangible assets.
Are amortization and depreciation the same?
Even though both concepts are frequently used as if they were one and the same, actually they are not exactly so. The difference lies in what goods or resources we are focusing on, that is, which is the assets that loses its worth.
Depreciation usually refers to tangible, fixed assets, such as machines or buildings.
As opposed to that, amortization is frequently used to refer to intangible, fixed assets.
What are intangible assets and tangible assets?
Intangible assets are non-material assets. Such assets may not be felt with the senses (they can’t be seen, our touched...) but they are still there. This is not a matter of faith, they are just non-material things such as patents, know-how, knowledge and abilities.
On the other hand, tangible assets are assets that may be seen and touched: material assets.
How can you work out the amortization or depreciation of an asset?
In order to work out the amortization or depreciation of an asset, we should consider several aspects and take several steps.
Write down all the data: amortizable value, useful life of the asset and remaining value
The amortizable value is the investment (or cost) the product required and we now want to profit from.
The useful life of the asset is, in other words, the time during which we will be able to use and take advantage of the resource.
The remaining value is the residual value of the asset once it has yielded all the profit that was expected from it. This value may be due to several things: other people or companies may still benefit from it using it the way it was supposed to be, or even because the material it is made up of may be used in some other way that provides value.
That would be the case of a machine made of copper: by using the copper in a different manner (for example by melting it) a significant value may be obtained.
Once the aforementioned data are obtained, working out amortization using the linear method is easy: you just need to determine the usage to be assigned to every year.
Substract the value assigned to the remaining value from the amortizable value
Divide the result obtained in the previous step by the expected years of useful life
Thus, if we buy a machine for 100,000 Euros, and the remaining value is 20,000 Euros, we will need to distribute the remaining 80,000 Euros of amortizable value all along the useful life of the machine.
If the expected lifespan is as long as 10 years, amortization will be 8,000 Euros per year (these are 80,000 Euros of amortizable value once the remaining value has been substracted from the initial value, and the result has been divided by 10 years of useful life).
Had you ever heard any of these concepts but still didn’t fully grasp what they meant? Do you think that all entrepreneurs should know what these concepts mean?