Depreciation and amortization are considered non-cash expenses because they do not involve an actual outflow of cash at the time they are recorded. The cash outflow for the asset occurred when it was initially purchased.
However, they impact profits because:
- Matching Principle: According to the matching principle in accounting, expenses should be recognized in the same period as the revenues they help generate. Assets like machinery, buildings, or intangible assets (patents, copyrights) contribute to revenue generation over multiple periods. Depreciation and amortization systematically allocate the cost of these assets over their useful lives, matching a portion of the asset's cost to the revenue it helps produce each period.
- Reduction of Taxable Income: By reducing a company's reported profit (net income), depreciation and amortization also reduce its taxable income. This leads to lower tax payments, which is a real cash saving, even though the expense itself is non-cash.
- Accurate Financial Reporting: Including these expenses provides a more accurate picture of a company's profitability by reflecting the consumption of its long-term assets. Without them, profits would appear artificially higher, as the cost of using these assets would not be accounted for in the period they are used.