What is Amortization?
There are three methods of expensing an asset to the income statement. The most common method is depreciation for fixed assets. 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 principal (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:
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 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 cash of $34,600 was expended 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 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. Act on Knowledge.
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