Amortization is the process of spreading out a loan (such as a home loan or auto loans) into a series of fixed payments. While each monthly payment remains the same, the payment is made up of parts that change over time. A portion of each payment goes towards interest costs (what your lendergets paid for the loan) and reducing your loan balance (also known as paying off the loan principal). Amortization can refer to the process of paying off debt over time in regular installments of interest and principal sufficient to repay the loan in full by its maturity date. With mortgage and auto loan payments, a higher percentage of the flat monthly payment goes toward interest early in the loan.
For intangible assets, however, a different system is needed, because there is no physical property that can depreciate. This is where amortization, a process by which companies may record the costs of an intangible asset in increments to allow for continued deductions, comes in. Amortization expenses accounts are where businesses record the periodic amounts being expensed. Your last loan payment will pay off the final amount remaining on your debt.
To record amortization of insurance expense, the company would debit the general and administrative expense account and credit the prepaid expense for the amount of amortization recognized. This entry reduces the company’s asset balance and increases expense. If the amount is determined to be equal each month and the policy lasts for one year, then the entry would be made for 1/12th of the cost of the policy.
The income statement also expenses certain assets as they are used over time. Tangible or fixed assets are written off in a process referred to as depreciation, while intangible assets are written off in a process referred to as amortization.
Is amortization expense a current asset?
Amortization is the process of incrementally charging the cost of an asset to expense over its expected period of use, which shifts the asset from the balance sheet to the income statement. Examples of intangible assets are patents, copyrights, taxi licenses, and trademarks.
You pay installments using a fixed amortization schedule throughout a designated period. And, you record the portions of the cost as amortization expenses in your books. Amortization reduces your taxable income throughout an asset’s lifespan. Certain kinds of intangible assets that don’t decrease in value over time should not be amortized, according to financial accounting regulations, but they are amortized for tax purposes.
With each subsequent payment, a greater percentage of the payment goes toward the loan’s principal. Amortization can be calculated using most modern financial calculators, spreadsheet software packages such as Microsoft Excel, or online amortization charts. Amortization is a method of spreading the cost of an intangible asset over a specific period of time, which is usually the course of its useful life. Intangible assets are non-physical assets that are nonetheless essential to a company, such as patents, trademarks, and copyrights. The goal in amortizing an asset is to match the expense of acquiring it with the revenue it generates.
The company determines the useful life of the asset and divides the purchase amount by the number of accounting periods occurring during that life. For example, a company purchases a patent for $120,000 and determines its useful life to be 10 years. The annual amortization expenses will be $12,000, or $1,000 a month if you are recording amortization expenses monthly. Amortization expense is an income statement account affecting profit and loss.
In company record-keeping, before amortization can occur, the purchase of the asset must be recorded. The cost of the asset is entered in a balance sheet account, with the offsetting entry to the account representing the method of payment, such as cash or notes payable.
Amortization is the process of incrementally charging the cost of an asset to expense over its expected period of use, which shifts the asset from the balance sheet to the income statement. It essentially reflects the consumption of an intangible asset over its useful life. Amortization is most commonly used for the gradual write-down of the cost of those intangible assets that have a specific useful life. Examples of intangible assets are patents, copyrights, taxi licenses, and trademarks.
Amortization is strictly limited to assets that are only useful for a determined span of time. Businesses use depreciation on physical assets such as buildings and equipment to spread the cost of the assets over time, allowing the expense to be deducted while the assets are in use.
The concept also applies to such items as the discount on notes receivable and deferred charges. Much of accounting is about matching expenses to the revenues in the accounting period they were incurred. For this reason, there are several accounting conventions that help to estimate the amount to expense or write off against sales.
A business records the cost of an intangible asset in the assets section of its balance sheet only when it purchases it from another party and the asset has a finite life. The company transfers a portion of the asset’s cost from the balance sheet to an expense on the income statement each accounting period.
The amount of principal due in a given month is the total monthly payment (a flat amount) minus the interest payment for that month. The next month, the outstanding loan balance is calculated as the previous month’s outstanding balance minus the most recent principal payment. The interest payment is once again calculated off the new outstanding balance, and the pattern continues until all principal payments have been made and the loan balance is zero at the end of the loan term. The length of time over which various intangible assets are amortized vary widely, from a few years to as many as 40 years.
- Amortization is an accounting technique used to periodically lower the book value of a loan or intangible asset over a set period of time.
- An amortization schedule is used to reduce the current balance on a loan, for example a mortgage or car loan, through installment payments.
This accounting treatment is required because of the matching principle, which calls for expenses to be recorded in the period that their benefit is received. Intangible assets are defined as those with a lack of physical existence but have a long-term benefit to the company. Amortization is most often applied to purchases of trademarks, patents, copyrights, licensing and contracts, properties that provide tangible benefit to the company but only for a certain length of time.
Why does Amortization matter?
The offsetting entry is a balance sheet account, accumulated amortization, which is a contra account that nets against the amortized asset. In accounting, the amortization of intangible assets refers to distributing the cost of an intangible asset over time.
Definition of Loan Payment
It does this instead of recording the entire cost as an expense on its income statement at the time of purchase. Amortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a period of time. Amortization and depreciation are non-cash expenses on a company’s income statement. Depreciation represents the cost of capital assets on the balance sheet being used over time, and amortization is the similar cost of using intangible assets like goodwill over time.
For example, amortization of goodwill for tax is a standard practice, using the 15 year period, but when it comes to financial accounting, amortization of goodwill isn’t done. Goodwill represents how much is paid in an acquisition beyond the apparent fair market value of a business. Amortization is the process of expensing the use of intangible assets over time as opposed to recognizing the cost solely in the year it is acquired. Many times when a business acquires something, the amount spent is immediately used to decrease income.
In much the same way that they depreciate physical property, companies use amortization to spread out the cost of an intangible asset that has a fixed useful life over the asset’s life. This method of recovering company capital is quite similar to the straight-line method of depreciation seen with physical assets. The alternative would be to absorb the full cost of the asset in a single accounting period, which would make profits for the period seem smaller and would violate the concept of matching expenses and revenue.
When something is amortized, the acquisition cost is divided by the asset’s “useful life,” and that amount is used to decrease a business’ income over a period of years. Useful life is a term that describes how long an asset can be used before it is depleted. Amortization is a common-sense accounting principle meant to reflect an economic reality. Just as the benefit of long-term goods such as intangible assets lasts over a period of years, the associated expense of acquiring that asset should be spread out over the same amount of time.
What Is Amortization? Definition and Examples
For example, after exactly 30 years (or 360 monthly payments) you’ll pay off a 30-year mortgage. Amortization tables help you understand how a loan works, and they can help you predict your outstanding balance or interest cost at any point in the future. For monthly payments, the interest payment is calculated by multiplying the interest rate by the outstanding loan balance and dividing by twelve.
As a general rule, an asset should be amortized over its estimated useful life, or the maturity or loan period in the case of a bond or a loan. If an intangible asset has an indefinite life, such as goodwill, it cannot be amortized.
Amortization is an accounting technique used to periodically lower the book value of a loan or intangible asset over a set period of time. First, amortization is used in the process of paying off debt through regular principal and interest payments over time. An amortization schedule is used to reduce the current balance on a loan, for example a mortgage or car loan, through installment payments. Second, amortization can also refer to the spreading out of capital expenses related to intangible assets over a specific duration – usually over the asset’s useful life – for accounting and tax purposes.
Business start-up costs may be amortized, too, but generally, they, as well as other intangible assets, can only be amortized for a maximum of 15 years. Some intangible assets provide benefit to a company for an indefinite period, but these may not be amortized.
What is an example of amortization?
Amortization expense is the write-off of an intangible asset over its expected period of use, which reflects the consumption of the asset. The accounting for amortization expense is a debit to the amortization expense account and a credit to the accumulated amortization account.