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Overview of Amortization
Definition of
Amortization
What is Amortization? Amortization is an accounting technique used to periodically lower the book value of an intangible asset over a set period. It conceptually mirrors Depreciation, which is used for tangible assets, but amortization applies specifically to assets without physical substance. Examples of intangible assets subject to amortization include patents, copyrights, trademarks, franchise agreements, and capitalized software development costs. Goodwill acquired in a business combination may also be amortized for tax purposes or tested for impairment under GAAP. The portion of the asset's cost allocated to each period is recorded as amortization expense on the Income Statement.
Activities Related to
Amortization
Here is a list of Amortization related activities:
Estimating the useful life of intangible assets (e.g., patent life, contract term), Selecting an appropriate amortization method (commonly the straight-line method), Calculating and recording periodic amortization expense via journal entries, Reducing the carrying value of intangible assets on the Balance Sheet, Performing impairment tests if an asset's value potentially drops below its book value, and Reporting amortization expense on financial statements.
These activities ensure the cost of intangible assets is systematically expensed over the periods they generate economic benefits.
The Importance of
Amortization
Amortization is important for businesses, including small businesses, because it accurately reflects the consumption of the economic benefits provided by intangible assets over time. By systematically allocating the cost of these assets as an expense, it adheres to the Matching Principle, pairing the expense with the revenue generated during the asset's useful life. This results in a more accurate representation of profitability on the Income Statement compared to expensing the entire cost upfront. Proper bookkeeping is essential for maintaining amortization schedules and making correct entries, contributing to reliable financial statements for decision-making and reporting.
Key Aspects of
Amortization
Cost Allocation for Intangibles
It is the process specifically designed for systematically expensing the cost of non-physical assets (like patents, copyrights, etc.) over their estimated useful lives.
Non-Cash Expense
Similar to depreciation, amortization expense recorded on the income statement reduces net income but does not represent an actual outflow of cash during that period.
Reduces Asset Book Value
Each period's amortization expense decreases the carrying value (book value) of the related intangible asset presented on the Balance Sheet. Accumulated amortization tracks the total expensed amount to date.
Concepts Related to
Amortization
Amortization is directly tied to Intangible Assets and is the counterpart to Depreciation (for tangible assets). It follows the Matching Principle by recognizing an expense (amortization expense) on the Income Statement over the asset's useful life. This process reduces the asset's value on the Balance Sheet. Methods like straight-line amortization are commonly used. It's a key concept in Accrual Accounting and standard bookkeeping procedures.
Amortization
in Action:
The Adventures of Coco and Cami
Follow the entrepreneurial journeys of Coco, who's opening a sandwich shop, and Cami, starting a coffee shop, as they find themselves faced with the new challenges of bookkeeping to track their businesses.
Watch as Professor A breaks down the fundamental concepts of bookkeeping for Coco and Cami, explaining why it's the essential foundation for understanding a business's financial health.