There are three methods of expensing an asset to the income statement. The most common method is depreciation. Mining, oil, and natural resource operations use depletion (amount removed versus the estimated volume on hand). Non-physical assets are expensed to the income statement or profit and loss statement via a method called amortization. It is most commonly used in the mortgage industry to refer to the monthly payment made to pay interest and the principle (the amortizable portion) on a debt instrument.
For most small businesses there are very few amortizable assets. The most commonly purchased non-physical assets include start-up costs, incorporation costs, loan fees, patents and goodwill. Typically, start-ups and incorporation costs are created from the very beginning of operations. The next most common is the closing costs for a loan on real estate or a long term note for the purchase of equipment. Patents and goodwill happen more frequently as the business matures.
These assets are first posted to the non-current assets section of the balance sheet with an offset account called accumulated amortization. Typically, amortization is calculated over the expected period of value and monthly straight line amounts are expensed to the income statement and accumulated in the ‘Accumulated Amortization’ balance.
As an example:
When a company starts-up it purchases a multitude of items to get going. It purchases its first initial license, pays for special permit fees to local government; spends money for drafted contracts with vendors, suppliers, and employees. It may purchase software that will be used for several years. Other costs include initial low or worthless physical assets such as cutlery and menus for a restaurant, training costs for staff, initial marketing/advertising package etc. All of these costs are accumulated and identified as ‘Start-Up Costs’. So assume the total is $34,600 expended to get ready for opening day.
Upon evaluation, you determine that these items will carry value for a period of 40 months before they become worthless or lost (cutlery disappears or wears out). Therefore, using straight line amortization, the $34,600 is divided by 40 to determine the monthly expense on the income statement labeled ‘Amortization of Start-Up Costs’ of $865.
On the balance sheet in the non-current assets section sits a line item identified Net Start-Up Costs which equals the original cumulative costs of $34,600 less any amount expensed to the income statement. So at the end of the 2nd month (2 unit charges of $865 each month) the balance sheet will show a balance in the Net Start-Up of $32,870. The best correlation of an image is the sand hour clock, the amortization flows in equal amounts over the time period of value just as the sand flows through the opening in equal amounts over the entire period of time.
It is important to understand a few critical aspects of amortization. First off, the asset on the balance sheet will rarely have any real business value especially for liquidation purposes. See http://businessecon.org/2013/01/liquidity-what-does-this-mean/ for a more detailed explanation of liquidity. Secondly, amortization is used in accounting to better match actual costs to the period of earnings associated with those costs.
Although we spent cash of $34,600 to procure the initial start-up items to get the business going (training, some desk items, permits, licenses, etc.), we can’t just expense this in the first month. It will distort the earnings of the business operation especially if your goal is to demonstrate realistic earnings from month to month for loan purposes or employee acquisition/retention. Furthermore, the asset has no real cash value, nobody is going to buy a permit from you or the initial training costs. A buyer sees this asset as zero value, so please understand that the intention for amortization is to not distort the income statement to the detriment of the balance sheet. This is one of the shortcomings of accrual accounting.
See How to Read the Balance Sheet – Simple Format for a better understanding of how to read a simple balance sheet.
For tax purposes, most amortizable items can be expensed out immediately under certain circumstances. However, the typical time frame allowed is 60 months (5 years). Some amortizable assets are only allowed to be amortized based on the period of time applicable to the master document that the asset is associated. An example would be a 15 year loan requiring several thousand dollars in closing fees (taxes, legal, documentation, points, etc.). This type of an asset is amortized over the life of the loan. In general, for tax purposes, they must match.
By understanding the concept of amortization a small business owner can appreciate the positive attributes and read his financial reports with a clearer understanding of the totality of those reports. Knowledge is Power.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.
If you found this article helpful, please consider a donation to the site. The donation button is just to the right. Even if you don’t make a contribution, I encourage you to read more articles on the website to help you become a better business entrepreneur.
Other articles related to amortization and using some of the same principles include the following:
Depreciation – This is Weird Accounting – similar to amortization, depreciation uses an extended period of time to fully recapture the cost associated with the initial capital investment. This article discusses the basic principles in depth.
The Definition of Fixed Assets – there are three requirements for a purchase to be defined as a fixed asset. First the item must be tangible, secondly, it must be purchased for third, business purposes.
What is Accrual Accounting? – depreciation and amortization are functions of accrual accounting. This article explains why accountants use this form of accounting.