Depreciation and Amortization
Depreciation and amortization (D&A) are non-cash accounting charges that systematically allocate the cost of tangible and intangible assets over their useful lives, reducing reported earnings while leaving operating cash flow unaffected.
When a company spends $100 million to build a manufacturing facility or purchase a piece of industrial equipment, it does not expense the full cost in the year of purchase. Instead, it capitalizes the expenditure on the balance sheet as a fixed asset and then recognizes the cost gradually over the asset's estimated useful life through a process called depreciation. An identical logic applies to acquired intangible assets such as patents or customer relationships, where the systematic cost allocation is called amortization. Together, D&A represents a non-cash reduction in reported earnings.
Depreciation methods under GAAP include straight-line (equal expense each year), declining balance (higher expense in early years, declining thereafter), and units-of-production (expense proportional to actual usage). The choice of method and useful-life assumptions affects reported earnings meaningfully: a company using a shorter depreciable life will report higher depreciation charges and lower near-term earnings than one using a longer life for the same asset. Airlines, for example, have historically differed in the useful lives they assign to aircraft — differences that create real comparability challenges across carriers.
Because D&A is a non-cash charge, it is added back to net income when computing cash flow from operations on the cash flow statement. This addback is one reason operating cash flow typically exceeds net income for capital-intensive businesses. EBITDA — earnings before interest, taxes, depreciation, and amortization — adds D&A back to operating income to produce a metric that better approximates cash earnings from operations before investment decisions. For asset-heavy businesses like utilities, industrials, and real estate, D&A can be the single largest line item on the income statement, making EBITDA and related cash flow metrics more central to valuation than net income.
A critical distinction for investors is the difference between 'economic depreciation' and accounting depreciation. Economic depreciation reflects the true decline in the productive capacity or market value of an asset. For technology equipment that becomes obsolete rapidly, accounting depreciation over five to seven years may actually understate the true economic erosion. For real estate that appreciates in value, accounting depreciation over 27.5 to 39 years represents a conservative overstatement of economic cost — which is one reason real estate investors focus on funds from operations (FFO), which adds back depreciation, as their primary performance metric.
Buffett has discussed D&A in Berkshire's annual letters as one of the most important areas where GAAP earnings diverge from economic reality: 'When we are buying, we are not buying accounting earnings. We are buying owner earnings.' His concept of owner earnings — net income plus D&A minus maintenance capex — attempts to separate the portion of D&A that represents real maintenance capital consumption from the portion that is merely accounting convention.