What Is Amortization? How Is It Calculated?

In business, amortization is the practice of writing down the value of an intangible asset, such as a copyright or patent, over its useful life. Amortization expenses can affect a company’s income statement and balance sheet, as well as its tax liability.

Calculating amortization for accounting purposes is generally straightforward, although it can be tricky to determine which intangible assets to amortize and then calculate their correct amortizable value. For tax purposes, amortization can result in significant differences between a company’s book income and its taxable income.

What Is Amortization?

Amortization is the accounting process of systematically allocating the cost of an intangible asset over the duration of its useful life. It’s similar in concept to depreciation, which is used for fixed tangible assets like machinery, but amortization is applied to intangible assets, such as copyrights, patents, and customer lists.

The term “loan amortization” is also used to describe how loan repayments are divided between interest charges and the reduction of outstanding principal, although that’s a completely different financial process. This article focuses on amortization as it relates to accounting and expense management in business. Under US Generally Accepted Accounting Principles (GAAP), this is guided primarily by ASC 350-30.

Key Takeaways

• Amortization is the accounting process used to spread the cost of intangible assets over the periods expected to benefit from their use.
• The customary method for amortization is the straight-line method.
• Determining which intangible assets may be amortized and the correct capitalized value can sometimes be tricky.
• Amortization rules differ significantly for tax versus book purposes.
• Applied correctly, amortization can result in significant tax savings.

Amortization in Business Explained

In business, accountants define amortization as a process that systematically reduces the value of an intangible asset over its useful life. It’s an example of the matching principle, one of the basic tenets of GAAP. The matching principle requires expenses to be recognized in the same period as the revenue they help generate, instead of when they’re paid.

Amortization impacts a company’s income statement and balance sheet. It also has a unique set of rules for tax purposes and can significantly impact a company’s tax liability.

How Is Amortization Calculated?

For book purposes, companies generally calculate amortization using the straight-line method. This method spreads the cost of the intangible asset evenly over all the accounting periods that will benefit from it.

The formula for amortization is:

Annual Amortization = Capitalized cost / Estimated useful life

Determining the capitalized cost of an intangible asset (the numerator in this equation) can be the trickiest part of the calculation. Say a company purchases an intangible asset, such as a patent for a new type of solar panel. The capitalized cost is the fair market value, based on what the company paid in cash, stock, or other consideration, plus other incidental costs incurred to acquire the intangible asset, such as legal fees.

Valuing intangible assets that were developed by your company is much more complex, because only certain expenses can be included. Say you develop patentable new solar technology internally. Only the costs to secure the patent, such as legal, registration, and defense fees, can be amortized. The costs incurred to develop the technology, such as R&D facilities and your engineers’ salaries, are deductible as business expenses. For tax purposes, there are even more specific rules governing the types of expenses that companies can capitalize and amortize as intangible assets, as we’ll discuss.

Calculating and maintaining supporting amortization schedules for both book and tax purposes can be complicated. Using accounting software to manage intangible asset inventory and perform these calculations will make the process simpler for your finance team and limit the potential for error.

Other Amortization Methods

The straight-line method is the most common approach for amortizing intangible assets, although GAAP does permit other methods when they better reflect the pattern in which the economic benefits of the intangible asset are consumed or used up. Several factors come into play when considering which method to choose. First, determine what mechanisms can reliably measure how the asset’s economic benefits are consumed. Second, make certain that the chosen method can be supported with objective evidence and documentation. Third, understand that the method must be applied consistently over time and to similar assets. Finally, evaluate whether the additional complexity of an alternative method provides materially better matching of expenses to revenue. In most cases, unless there’s a clear and demonstrable pattern of consumption that differs from straight-line, companies default to the straight-line method for its simplicity and consistency.

Units of Production Method

The units of production method amortizes an intangible asset based on actual usage or output rather than the passage of time. This method can be appropriate when the consumption of the intangible asset is directly tied to production volume or usage levels. It requires estimates of the total expected units over the intangible asset’s useful life and the ability to measure the actual units produced in each accounting period. An example is a patent for a drug formulation where the patent’s value diminishes with each unit manufactured.

Accelerated Method

An accelerated amortization method may be used if a company can demonstrate that an intangible asset provides greater economic benefit in its earlier years. For example, a customer list might generate more revenue initially, with declining value as customers leave over time. However, accelerated amortization methods for intangibles are uncommon in practice because the burden of proof is on the company to demonstrate the pattern of economic benefit; most intangible assets don’t have a clearly measurable declining benefit pattern; and auditors require substantial justification to support them.

Video: Amortization Defined

Amortization of Intangibles

Amortization applies to intangible assets with an identifiable useful life—the denominator in the amortization formula. The useful life, for book amortization purposes, is the asset’s economic life (the expected period during which an asset is useful to the owner) or its contractual/legal life (the time until, for example, a patent or license expires), whichever is shorter.

Limiting factors, such as regulatory issues or obsolescence, can make an asset’s economic life shorter than its contractual or legal life. Examples of amortizable intangible assets include:

• Patents
• Copyrights
• Franchises
• Trademarks
• Software developed for internal use (not sold to customers)
• Customer lists
• Licenses

In contrast, intangible assets that have indefinite useful lives, such as goodwill, are generally not amortized for book purposes, according to GAAP. Instead, they’re periodically reviewed to determine whether their value has decreased—this is known as impairment of value. Companies record any write-down as a loss on the P&L, not as an amortization expense. There are some limited exceptions to this rule that allow privately held businesses to amortize goodwill over a 10-year period.

A company’s intangible assets are disclosed in the long-term asset section of its balance sheet, while amortization expenses are listed on the income statement, or P&L. However, because amortization is a non-cash expense, it’s not included in a company’s cash flow statement or in some profit metrics, such as earnings before interest, taxes, depreciation, and amortization (EBITDA).

Amortization Schedules

An amortization schedule is a table that displays the expected allocation of an intangible asset’s cost over its useful life. It shows the asset’s value at the start of each period, the amortization expense recognized during the period, and the asset’s remaining book value at the end of each period (also called net book value or carrying value).

During the accounting close process, finance teams rely on these schedules to record accurate amortization journal entries. In addition, amortization schedules are used to forecast future amortization expenses, provide documentation for auditors, support GAAP-compliant financial reporting, and monitor the book value of intangible assets over time. When maintained separately for book and tax purposes, they’re used to reconcile differences in amortization treatment.

For companies with many intangible assets, maintaining amortization schedules can become burdensome, because each asset has a different acquisition date, useful life, and amortization method. Accounting software can centralize intangible asset records and automatically generate amortization schedules, which often directly update the general ledger.

Amortization Schedule Example

The following amortization schedule illustrates the fact pattern in the ABZ Inc. example in the “Example of Amortization” section a bit further down in the article.

Amortization for Tax Purposes

The IRS may require companies to apply different useful lives to intangible assets when calculating amortization for taxes. This variation can result in significant differences between the amortization expense recorded on the company’s books and the figure used for tax purposes.

The IRS calls the assets in the list above, such as patents and trademarks, Section 197 intangibles after the section of the tax code in which they’re defined. It requires companies to apply a 15-year useful life when calculating amortization for these assets for tax purposes.

Intangible assets that are outside this IRS category are amortized over differing useful lives, depending on their nature. For example, computer software that’s readily available for purchase by the general public isn’t considered a Section 197 intangible, and the IRS suggests amortizing it over a useful life of 36 months.

One notable difference between book and amortization is the treatment of goodwill that’s obtained as part of an asset acquisition. IRS publication 535, which covers business expenses, allows companies to use straight-line amortization of goodwill over a period of 180 months for tax purposes, whereas they must test for impairment and record any resulting loss for book purposes.

Example of Amortization

Many examples of amortization in business relate to intellectual property, such as patents and copyrights. Here’s a typical situation:

• Company ABZ Inc. paid an outside inventor $180,000 for the exclusive rights to a solar panel she developed.
• ABZ spent $20,000 to register the patent, transferring the rights from the inventor for 20 years.
• News of the sale caused two other inventors to challenge the application of the patent. ABZ successfully defended the patent but incurred legal fees of $50,000.

Free Amortization Work Sheet

Amortization vs. Depreciation: What’s the Difference?

Amortization and depreciation are similar in that they both support the GAAP matching principle of recognizing expenses in the same period as the revenue they help generate. However, there are significant differences between them:

• Intangible versus tangible assets: Amortization is used for intangible assets, while depreciation is used for tangible, fixed assets, such as office equipment or buildings.
• Cause of reduced asset value: Amortization generally reflects an intangible asset’s loss in value due to circumstances like contract expiration or obsolescence. In contrast, depreciation reflects the fact that a fixed asset loses value as it wears out or becomes consumed.
• Applicability: Amortization applies only to intangible assets with finite, identifiable useful lives and not those with indefinite useful lives, while depreciation is generated for every fixed asset, excluding land.
• Salvage value: Amortization is most often calculated on the entire value of an intangible asset, while depreciation typically assumes that a fixed asset has a salvage value.
• Journal entries: Amortization expense is charged (debited) to the P&L expense account with an offsetting credit directly in the intangible asset account. In contrast, depreciation is credited to accumulated depreciation, a contra-asset account.

Amortizing Startup Costs

Entrepreneurs often incur startup costs to organize a business before it begins operating. These startup costs may include legal and consulting fees as well as marketing expenses and are an example of an area where there’s a significant difference between book amortization and tax amortization. Under GAAP, for book purposes, any startup costs are expensed as part of the P&L; they’re not capitalized into an intangible asset.

For tax purposes, however, some startup and organizational costs may be capitalized and amortized over periods up to 15 years, after taking initial deductions in the first year of operations. Determining which payments can be capitalized, and maintaining the associated additional amortization schedules, can be a tedious process. If a company hasn’t already implemented a robust accounting system, as part of its startup efforts, additional bookkeeping expertise may be needed.

Simplify and Automate Amortization With NetSuite Financial Management

For companies dealing with intangible assets and prepaid expenses, NetSuite financial management solutions, can simplify the amortization process. NetSuite’s automation powers amortization schedules for items such as prepaid insurance and software licenses while posting to the general ledger for faster, more accurate statements. NetSuite also maintains a detailed record of all amortization transactions to support compliance with regulatory standards such as IFRS and GAAP. Combined together, these powerful features make NetSuite an ideal choice for both start-ups and established corporations looking to maximize accounting benefits through amortization.

Amortization spreads the cost of intangible assets over their useful lives, matching expenses to the most appropriate periods for maximum benefit. Understanding amortization involves knowing which assets qualify for amortization, how to determine their capitalized cost and create amortization schedules, and how to navigate the significant differences between book and tax treatment. The right accounting systems make the process easier for more accurate financial reporting.

Amortization FAQs

What is amortization in simple terms?

Amortization is the gradual expense of an intangible asset’s cost over its useful life. It spreads the asset’s value over periods that benefit from it in accordance with the matching principle, which requires expenses to be recognized in the same period as the revenue they helped to generate instead of when they’re paid.

Is amortization a liability or an expense?

Amortization is a non-cash expense. It reduces the book value of an intangible asset over time in line with the matching principle, but it doesn’t create a liability.

What are the disadvantages of amortization?

Amortization reduces reported net income and is a non-cash expense that can complicate cash flow analysis. It relies on estimates of useful life, which can cause misstated asset values or future adjustments.

Is goodwill amortized?

Under US Generally Accepted Accounting Principles, goodwill isn’t amortized. Instead, it’s tested for impairment at least annually. Some private companies and nonprofit organizations may be eligible for an alternative that allows goodwill amortization over 10 years or less.