Amortization (business)
Amortization in business refers to the accounting practice of systematically spreading out expenses over time, primarily for intangible assets like patents, licenses, and intellectual property. This approach helps businesses avoid reporting a significant loss on their balance sheets, which can negatively affect investor sentiment. Instead of recognizing one large expense when acquiring an intangible asset, companies can allocate smaller expenses over the asset's useful life, thereby stabilizing reported profits.
Amortization is applicable not only to intangible assets but also to goodwill, which arises when a company is purchased for more than its tangible asset value. Businesses typically utilize an amortization schedule to track how these assets are depreciated each year, employing either the straight-line method, which distributes expenses evenly, or the accelerated method, which emphasizes larger early-year expenses. Proper amortization involves several steps, including verifying the asset's nature, determining its initial cost, estimating its useful life, and calculating annual amortization. Compliance with accounting standards such as GAAP and IFRS is essential, as these standards dictate how amortization and asset valuation must be managed and reported.
On this Page
Amortization (business)
In business, amortization is an accounting practice that involves spreading out business expenses over time. Businesses use amortization so their balance sheets do not show one large loss. Amortization limits the negative impact expenses can have and generally keeps shareholders and investors happy.
Many companies use amortization for intangible assets such as patents, licenses, and intellectual property. Amortization represents the cost as the asset is consumed while it is producing profits for the company. Amortization allows a business to register small expenses over time for such assets. Besides intangible assets, a private company can amortize goodwill, which occurs if the company was purchased for more money than it was worth.
Businesses typically use an amortization schedule to calculate how intangible assets are written down each year. One of two methods, the straight-line method or the accelerated method, can be used. Furthermore, companies must follow certain steps to properly amortize an asset, including using a formula to calculate the amortization per year. Companies must also account for amortization according to the major accounting standards—the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS).
Overview
A business uses amortization so as not to report one large loss on its balance sheet. Businesses use a balance sheet to measure their success. A balance sheet documents a company’s earnings and expenses and determines whether a given year was profitable or not. In general, amortization limits the negative impact of expenses and helps satisfy shareholders and investors.
Businesses primarily use amortization for intangible assets, which are non-physical assets that have value to the business, including patents, copyrights, licenses, permits, brand names, intellectual property, and research and development (R&D). The term depreciation is used for tangible assets, such as equipment, delivery trucks, and office furniture. A company seeking to secure a patent may amortize the cost of the patent. The company must pay for the patent and also pay a patent attorney. However, because a patent’s legal life is seventeen years, the business may spread out the cost of the patent over those seventeen years. In other words, the business can register seventeen small expenses over the next seventeen years instead of registering one large expense. That way, the business’s profits will not suffer as much.
Some private companies amortize goodwill. Goodwill comes into play when a company is bought and the buyer pays more for it than it is worth. Goodwill is the purchase price amount that surpasses the value of the company’s assets. In other words, it is the difference between the amount the buyer paid and the actual fair value of the company’s assets. Such businesses are given the ability to amortize this goodwill. However, the amortization of goodwill cannot exceed ten years. In the past, a company had to conduct a lengthy and expensive annual valuation to determine whether the goodwill had diminished in value. But in 2014, an alternative gave private companies the option to forgo the annual valuation and amortize the goodwill. These businesses, however, must still conduct a valuation if some event causes the recorded value of the company to exceed its fair market value.
Businesses often calculate an amortization schedule, which shows how intangible assets are written down each year. One of two methods can be used—the straight-line method or the accelerated method. The straight-line method, which is the more common method, applies an equal amortization expense to the asset each year. The accelerated method, also called the double-declining balance method, applies more expense in early years and less expense in later years. Regardless of which method is used, the total amortization expense of the asset is the same.
Several steps must be followed to properly amortize an asset. Amortization should begin as soon as the asset is obtained or made available. The first step is to verify that the asset is intangible and has measurable effect that benefits the business. The next step is to determine the asset’s initial cost. For example, if the asset is a patent, the initial cost would be the amount of money it costs to purchase the patent. The business owner must then establish the estimated useful life of the asset, such as seventeen years for a patent. The final step is to calculate the amortization per year. The following formula should be used in this step: initial cost / useful life = amortization per year.
Businesses must account for amortization according to the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS), the major accounting standards. However, the two standards differ in the way intangible assets are adjusted over time. For example, IFRS permits revaluing the value of an intangible asset, but GAAP does not permit this. Therefore, companies can account for GAAP changes in value by changing amortization schedules or writing down the value of an intangible asset, making it permanent. In addition, IFRS recognizes a prepayment of advertising expenses as assets, while GAAP requires that these expenses are expenses as incurred.
Bibliography
Bronson, Gary J., et al. Mathematics for Business. 7th ed., Mercury Learning & Information, 2021, search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=3061469. Accessed 20 Oct. 2024.
Fontinelle, Amy. "What Is an Amortization Schedule? How to Calculate with Formula." Investopedia, 24 Oct. 2024, www.investopedia.com/terms/a/amortization.asp. Accessed 25 Oct. 2024.
"How Does Goodwill Amortize?" Investopedia, 12 May 2024, www.investopedia.com/ask/answers/010815/how-does-goodwill-amortize.asp. Accessed 20 Oct. 2024.
Kaszkurewicz, Eugenius, and Amit Bhaya. Business Dynamics Models: Optimization-Based One Step Ahead Optimal Control. Society for Industrial and Applied Mathematics, 2022.
Ross, Sean. "Amortization vs. Depreciation: What's the Difference?" 31 Aug. 2024, Investopedia, www.investopedia.com/ask/answers/06/amortizationvsdepreciation.asp. Accessed 20 Oct. 2024.
Roos, Dave. “How Amortization Works.” HowStuffWorks, money.howstuffworks.com/personal-finance/debt-management/amortization.htm. Accessed 20 Oct. 2024.