What is Amortization in Accounting and How is it Calculated?

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In other words, the depreciated amount expensed in each year is a tax deduction for the company until the useful life of the asset has expired. Amortization is an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period of time. Concerning a loan, amortization focuses on spreading out loan payments over time. When applied to an asset, amortization is similar to depreciation.

Small Business Accounting: What Is Amortization?

In general, the word amortization means to systematically reduce a balance over time. In accounting, amortization is conceptually similar to the depreciation of a plant asset or the depletion of a natural resource. An agile finance team will be prepared not just for current expenses but for the future too. With amortization’s help, you will know how much you will incur in the future because of your loans and assets. At the same time, any accumulated amortization is added to the credit side of the journal.

• Land is one of the rare examples where a physical asset should never be depreciated.
• Thus, it writes off the expense incrementally over the useful life of that asset.
• For example, a business may buy or build an office building, and use it for many years.
• After she has made her final payment, she no longer owes anything, and the loan is fully repaid, or amortized.
• When the first payment is made, part of it is interest and part is principal.

In short, it describes the mechanism by which you will pay off the principal and interest of a loan, in full, by bundling them into a single monthly payment. This is accomplished with an amortization schedule, which itemizes the starting balance of a loan and reduces it via installment payments. A loan doesn’t deteriorate in value or become worn down over use like physical assets do. Loans are also amortized because the original asset value holds little value in consideration for a financial statement. Though the notes may contain the payment history, a company only needs to record its currently level of debt as opposed to the historical value less a contra asset.

How Do You Amortize a Loan?

This can be useful for purposes such as deducting interest payments for tax purposes. Amortizing intangible assets is also important because it can reduce a company’s taxable income and therefore its tax liability, while giving investors a better understanding of the company’s true earnings. A company’s intangible assets are disclosed in the long-term asset section of its balance sheet, while amortization expenses are listed on the income statement, or P&L. Amortization is the systematic write-off of the cost of an intangible asset to expense. A portion of an intangible asset’s cost is allocated to each accounting period in the economic (useful) life of the asset.

For tax purposes, there are even more specific rules governing the types of expenses that companies can capitalize and amortize as intangible assets, as we’ll discuss. Say a company purchases an intangible asset, such as a patent for a new type of solar panel. The capitalized cost is the fair market value, based on what the company paid in cash, stock or other consideration, plus other incidental costs incurred to acquire the intangible asset, such as legal fees. This is because the costs incurred for intangible assets are not always direct.

Amortized Cost vs. Amortization

Amortization, in accounting, refers to the technique used by companies to lower the carrying value of either an intangible asset. Amortization is similar to depreciation as companies use it to decrease their book value law firm bookkeeping or spread it out over a period of time. Amortization, therefore, helps companies comply with the matching principle in accounting. In addition to loans, you may also spread out the cost of your intangible assets.