Amortization

• For intangible assets: Spreading the cost of an intangible asset over its useful life.
• For loans: Spreading out loan payments over time, gradually reducing the loan balance.

Amortization of Intangible Assets

This applies to assets like:

• Patents
• Copyrights
• Trademarks
• Goodwill
• Software (in some cases)

👆 Fun fact: The word “amortization” comes from the Latin “admortire,” which means “to kill.” In accounting, we’re “killing off” the value of an asset over time.

Formula for Amortization:

Annual Amortization Expense = (Asset Cost – Residual Value) / Useful Life

Example:

Imagine your tech company buys a patent for $100,000:

• Cost: $100,000
• Expected useful life: 10 years
• Residual value: $0

Annual Amortization = ($100,000 – $0) / 10 = $10,000 per year

Each year for 10 years, you’ll record an amortization expense of $10,000 on your income statement. On your balance sheet, you’ll reduce the value of the patent by the same amount.

Understanding Amortization vs Depreciation 📊

These are two ways to track how assets lose value over time, but they’re used for different things! 💫

Depreciation

• Used for physical stuff (tangible assets)
• Like cars, computers, machinery
• Things you can touch and feel
• Example: Your company car losing value each year

Amortization

• Used for non-physical stuff (intangible assets)
• Like patents, copyrights, software
• Things you can’t touch
• Example: Spreading the cost of a patent over its legal life

Loan Amortization

This is the process of paying off a loan with regular payments that cover both the principal and interest. Each payment goes partly toward the loan principal and partly toward interest.

Typical Loan Amortization Schedule:

Notice how the principal portion increases over time, while the interest portion decreases? That’s amortization in action!

Why Does Amortization Matter?

For Intangible Assets:

• Helps match the cost of the asset with the revenue it generates over time.
• Impacts a company’s reported profits and asset values.
• Can provide tax benefits (amortization expenses are often tax-deductible).

For Loans:

• Provides a clear repayment schedule for borrowers.
• Helps lenders manage risk and calculate returns.
• Affects a borrower’s balance sheet and income statement over time.

Amortization and Financial Statements

Amortization impacts financial statements in a few ways:

• On the Income Statement: It’s an expense for intangible assets, reducing profit.
• On the Balance Sheet: It reduces the value of intangible assets over time.
• For loans: It gradually shifts the balance from liability to owner’s equity.