Amortizing the value of an intangible asset can be spread over years or months.
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What Is Amortization?
Amortization is writing down the value of an asset or the payment of a loan over a period. From a company perspective, it would be amortizing expenses for assets, particularly intangible assets such as intellectual property rights. From a banker’s perspective, it’s stretching the payment period of a loan to provide the borrower the flexibility to repay at a fixed amount.
In accounting parlance, amortization is the process of allocating the costs of long-lasting assets, or “long-lived assets,” over a period during which those assets are projected to provide economic benefits. This article focuses mainly on how companies handle the amortization of intangible assets.
Amortization tends to be associated with depreciation, which focuses on physical assets such as plants, machinery and equipment. (Some accountants and analysts tend to omit property on the premise that property doesn’t depreciate.) A company amortizes intangible assets such as copyrights, patents, trademarks, software, licenses or other forms of rights to intellectual property due to obsolescence or the adaption of new technologies. A 5-year patent nears expiration, and the company needs to write down the value of the remaining years of the rights. A copyright acquired during an acquisition will soon end, and the company wants to amortize that.
Large companies that have many subsidiaries and have been operating for a long time typically have intangible assets that can be amortized. At the same time, start-up companies also amortize expenses on assets tied to the cost of establishing their business.
How Is Amortization Calculated?
Exactly how amortization is calculated depends on what specifically is being written down. Here, it is broken down for intangible assets and loans.
Amortization Calculation for Assets
Calculating amortization requires estimating the useful life of an asset. When a company acquires a rival and its patents, the company can immediately amortize what it estimates to be the lifespan of the patents over a period. If the company wants to amortize a patent but can’t determine the lifespan, it would use the straight-line method of amortization, which means reducing the value of the asset at a consistent rate over a period until the end value is zero.
Under the straight-line method:
Amortization Expense = (Cost – Residual Value) / Useful Life in Periods
In one example, a patent valued at $10 million is being amortized over 5 years with no residual value, which means that the value of the patent at the end of the 5th year will be zero. Using the straight-line formula, ($10,000,000 – $0) / 5 = $2,000,000, $2 million is the amortization expense per year.
The table below highlights that straight-line method:
On journal entries, the patent’s amortization would appear as such, per period:
Amortization Calculation for Loans
There are two common methods of amortization on loans: straight-line, as mentioned above with assets, and mortgage-style. Either method can be used on different types of loans: home equity, auto, and personal.
Amortization of Loans = (Principal + Interest) / Number of Periods
In the table below, using the straight-line method, a $10,000 loan carries an annual interest of 6 percent, and a fixed payment of $500 per month. As the balance decreases each month, the interest payment also declines, but the principal payment increases. After calculating the principal payment and interest per month, the loan is likely to be paid in 22 months.
In mortgage-style amortization, for that same $10,000 loan with an annual interest rate of 6 percent, the interest payments initially will be higher than the principal. But payment on principal and interest tend to be even midway through the length of the amortization period.
Where Is Amortization Found in the Financial Statement?
For many companies, amortization is an expense item that can be found in the income statement of the financial statement filed quarterly and annually with the Securities and Exchange Commission. Amortization tends to be grouped with depreciation as a single item within operating expenses because they focus on writing down the value of assets during that period of the financial statement. In some cases, expenses for depreciation and amortization might be minute and would be lumped with selling, general, and administrative costs.
Amortization, like depreciation, is a non-cash expense because the value of the asset is being written down over a period, but it does reduce earnings on the income statement. Still, amortization, along with depreciation, will appear in the cash flow statement to point out specific costs tied to the write-down of certain assets.
Where Is Amortization Used?
Amortization is used in measures such as EBITDA, which stands for earnings before interest, taxes, depreciation and amortization. For EBITDA, depreciation and amortization are among the items added back to net income to show investors how a company is achieving profit primarily on an operating basis.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about amortization.
Are Amortization and Depreciation the Same?
Both are similar in concept of writing down assets over time, but amortization focuses on intangible assets, and depreciation revolves around physical assets.
Is Goodwill Amortized?
Goodwill, which are intangible assets acquired via merger or acquisition that cannot be attributed to other income-producing assets, and intangible assets with indefinite lifespan are not amortized.
Is Amortization Tax Deductible?
Amortized items can be deducted from tax liabilities because of the write-down on their value.
