Most business assets aren't designed to last forever, and accounting for those assets is an important aspect of managing a company's finances. Amortization is an accounting term that deals with the cost allocation of an intangible asset. With amortization, a business will write off the cost of an intangible asset over the course of its useful life -- a process that reduces its assets and stockholders' equity on its balance sheet. In the context of mortgage and auto loans, amortization also refers to the repayment of principal over a certain period of time.
Image source: Getty Images.
Amortization in accounting
When a company amortizes an asset, it is spreading out the cost of that asset over the course of its useful life. Amortization roughly matches the expense of an asset with the revenue it brings in. As a business writes off an asset, that asset is shifted from the balance sheet to the income statement. Amortization is used to write off intangible assets that have a specific useful life. Patents, copyrights, and licenses are good examples of intangible assets that can be amortized. Because all of these items come with expiration dates, it's possible to calculate how much of each asset has been used up at any given point in time.
Calculating amortization
To calculate amortization, we start by taking the initial cost to acquire an asset and then subtract its salvage value, which is the estimated resale value of an asset at the end of its useful life. We then divide that number by the asset's useful life. Because many intangible assets aren't worth anything at end of their useful life, calculating amortization is often a simple matter of taking the cost to acquire an asset and dividing it by its useful life.
Let's say a company spends $20,000 to obtain a patent with a useful life of 10 years, and that once the patent expires, it's not worth anything. In this case, the company would record $2,000 each year as an amortization expense for the patent ($20,000 — $0 = $20,000/10 = $2,000).
Amortization in lending
In the context of lending, amortization is the process of paying off debt with a fixed repayment schedule over a specified period of time. Amortization typically comes into play with mortgages and auto loans. A loan's amortization schedule will show how each loan payment is applied to principal and interest until the loan balance is eventually reduced to $0. Typically, in the early years of a loan, the amortization schedule will show that a larger proportion of each loan payment is applied to interest and less so to principal, whereas toward the end of a loan, a larger proportion is applied to principal and less so to interest.
Amortization versus depreciation
Both amortization and depreciation are accounting methods used to write off the cost of an asset. But whereas amortization applies to intangible assets, depreciation applies to tangible assets, such as equipment and vehicles.
The concept of salvage value is more likely to come up with depreciation than amortization. Let's say a company buys a piece of machinery for $50,000 with a useful life of five years. At the end of those five years, the machine may no longer work efficiently, but the company might be able to sell it for parts and get $5,000 for it. In that case, the company would record $9,000 each year as a depreciation expense ($50,000 — $5,000 = $45,000/5 = $9,000).
Amortization helps businesses understand how they're using their assets. Just as importantly, decreasing an asset's value over time is a good way to help reduce a company's taxable income, which is something all businesses are eager to do.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
