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:

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’. 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. 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 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.

Value Investing

Do you want to learn how to get returns like this?

Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.

There are four key principles used with value investing. Each is required. They are:

  1. Risk Reduction – Buy only high quality stocks;
  2. Intrinsic Value – The underlying assets and operations are of good quality and performance;
  3. Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
  4. Patience – Allow time to work for the investor.

If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above. 

Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:

  1. Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
  2. Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
  3. Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.

Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:

  • Lessons about value investing and the principles involved;
  • Free webinars from the author following up the lessons;
  • Charts, graphs, tutorials, templates and resources to use when you create your own pool;
  • Access to existing pools and their respective data models along with buy/sell triggers;
  • Follow along with the investment fund and its weekly updates;
  • White papers addressing financial principles and proper interpretation methods; AND
  • Some simple good advice.

Value Investment Club

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