Amortization
Amortization
Amortization is an accounting practice whereby expenses or charges are accounted for as the useful life of the asset is consumed or used rather than at the time they are incurred. Amortization includes such practices as depreciation, depletion, write-off of intangibles, prepaid expenses and deferred charges. By amortizing an asset or liability the value of the item is reduced gradually over time by some periodic amount (i.e., via installment payments). In the case of an asset, it involves expensing the item over the "life" of the item—the time period over which it can be used. For a liability, the amortization takes place over the time period that the item is repaid or earned. Amortization is essentially a means to allocate categories of assets and liabilities to their pertinent time period.
The key difference between depreciation and amortization is the nature of the items to which the terms apply. The former is generally used in the context of tangible assets, such as buildings, machinery, and equipment. The latter is more commonly associated with intangible assets, such as copyrights, goodwill, patents, and capitalized costs (e.g., product development costs). On the liability side, amortization is commonly applied to deferred revenue items such as premium income or subscription revenue (wherein cash payments are often received in advance of delivery of goods or services), and therefore must be recognized as income distributed over some future period of time.
Amortization is a means by which accountants apply the period concept in accrual-based financial statements: income and expenses are recorded in the periods affected, rather than when the cash actually changes hands. The importance of spreading transactions across several periods becomes clearer when considering long-lived assets of substantial cost. Just as it would be inappropriate to expense the entire cost of a new facility in the year of its acquisition since its life would extend over many years, it would be wrong to fully expense an intangible asset only in the first year. Intangible assets such as copyrights, patents, and goodwill can be of benefit to a business for many years, so the cost of accruing such assets should be spread over the entire time period that the company is likely to use the asset or generate revenue from it.
The periods over which intangible assets are amortized vary widely, from a few years to as many as 40 years. The costs incurred with establishing and protecting patent rights, for example, are generally amortized over 17 years. The general rule is that the asset should be amortized over its useful life. Small business owners should realize, however, that not all assets are consumed by their use or by the passage of time, and thus are not subject to amortization or depreciation. The value of land, for example, is generally not degraded by time or use. In fact, the value of land often increases with time. This applies to intangible assets as well; trademarks can have indefinite lives and can increase in value over time, and thus are not subject to amortization.
The term amortization is also used in connection with loans. The amortization of a loan is the rate at which the principal balance will be paid down over time, given the term and interest rate of the note. Shorter note periods will have higher amounts amortized with each payment or period.
see also Accounting Methods; Assets;Loans
BIBLIOGRAPHY
Cornwall, Dr. Jeffrey R., David Vang, and Jean Hartman. Entrepreneurial Financial Management. Prentice Hall, 13 May 2003.
Davis, Jon E. "Amortization of Start-Up Costs." The Tax Adviser. April 1999.
Mueller, Jennifer L. "Amortization of Certain Intangible Assets: Companies Should Question the Treatment of Assets with Contractual or Legal Lives." Journal of Accountancy. December 2004.
Pinson, Linda. Keeping the Books: Basic Record Keeping and Accounting for the Successful Small Business. Business & Economics, 2004.
Hillstrom, Northern Lights
updated by Magee, ECDI
Amortization
AMORTIZATION
The reduction of a debt incurred, for example, in the purchase of stocks or bonds, by regular payments consisting of interest and part of the principal made over a specified time period upon the expiration of which the entire debt is repaid. A mortgage is amortized when it is repaid with periodic payments over a particular term. After a certain portion of each payment is applied to the interest on the debt, any balance reduces the principal.
The allocation of the cost of an intangible asset, for example, a patent orcopyright, over its estimated useful life that is considered an expense of doing business and is used to offset the earnings of the asset by its declining value. If an intangible asset has an indefinite life, such as good will, it cannot be amortized.
Amortization is not the same as depreciation, which is the allocation of the original cost of a tangible asset computed over its anticipated useful life, based on its physical wear and tear and the passage of time. Amortization of intangible assets and depreciation of tangible assets are used for tax purposes to reduce the yearly income generated by the assets by their decreasing values so that the tax imposed upon the earnings of assets is less. Amortization differs from depletion, which is a reduction in the book value of a natural resource, such as a mineral, resulting from its conversion into a marketable product. Depletion is used for a similar tax purpose as amortization and depreciation—to reduce the yearly income generated by the asset by the expenses involved in its sale so that less tax will be due.
amortize
am·or·tize / ˈamərˌtīz/ • v. [tr.] reduce or extinguish (a debt) by money regularly put aside: loan fees can be amortized over the life of the mortgage. ∎ gradually write off the initial cost of (an asset): they want to amortize the tooling costs quickly.DERIVATIVES: am·or·ti·za·tion / ˌamərtiˈzāshən; əˌmôrti-/ n.
amortize
Hence amortization XVII; in medL. admortizātiō.