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In accounting, amortization refers to a method used to reduce the cost value of a tangible or intangible asset through increments scheduled throughout the life of the asset.
To amortize is to pay off debt with fixed repayment installments in intervals over some time, like a car loan or mortgage. Capital expenses get spread out for the asset’s useful life.
Amortization also refers to loan repayment over time in regular installments of principal and interest satisfactorily, to repay the loan in its entirety as it matures.
Deducting capital expenses over an asset’s useful life is an example of amortization, which measures the use of an intangible asset’s value, such as copyright, patent, or goodwill.
A Little More on What is Amortization
Amortization is a financial procedure by which costs and charges get accounted for as the useful life of an asset gets used instead of at the moment the expenses were incurred.
Amortization is carried out to the following assets or liabilities:
- Deferred charges
- Prepaid expenses
- Intangible Assets
To amortize an asset or liability means to lessen its value gradually over time by amounts at fixed intervals, such as installment payments. The item gets charged as a cost for the period it can be used, or its useful life. The amortization of liability occurs over the time the item is earned or repaid. In essence, the accounting practice is a method of assigning a classification of assets and liabilities to their relevant time.
There is a fundamental difference between amortization and depreciation. Depreciation typically relates to tangible assets, like equipment, machinery, and buildings. Amortization, however, involves intangible assets, such as patents, copyrights, and capitalized costs. With liabilities, amortization often gets applied to deferred revenue, such as cash payments usually received before delivery of services or goods. It’s income earned over a future length of time.
Amortization is the way accountants assign the period concept in financial statements based on accrual. For example, expenses and income get recorded in the period concerned instead of when the money changes hands.
You wouldn’t charge the whole cost of a new building in the acquisition year because the life of the asset would extend many years. Even with intangible goods, you wouldn’t want to expense the cost a patent the very first year since it offers benefit to the business for years to come. That’s why the costs of gaining assets throughout the years are significant because the company can continue to use it or create revenue from it.
There is no set length of time am intangible asset can amortize— it could be for a few years to 30 years. The value of an asset should decrease throughout its useful life. Not all assets are subject to amortization or depreciation. Some assets like land or trademarks can increase in value with passaging time and use.
You can also apply the term amortization to loans which would refer to the pace that the principal balance will get paid down over time, considering the interest and term rate.
Example of Amortization an Asset
A company purchases the patent on a machine for 30,000 dollars. The useful life of the patent for accounting purposes is deemed to be 5 years. So, the asset is amortized at 20% per year or 6,000 dollars per year. The accumulated amortization is the total value of the asset amortized since it was acquired.
References for Amortization
Academic Research for Amortization
- Valuation and amortization, Preinreich, G. A. (1937). Accounting Review, 209-226. Preinreich discusses how many accountants appear to be lacking a real idea of what a balance sheet is, which they believe is a statement of a business’ worth. The author concludes that accounting is not a process of valuation. Instead, the approach is historical, and appraisal is sometimes included as security. According to Preinreich, “book value” is vague and “book figure” is a more accurate way of describing it. The balance sheet, the author insists, is a “highly technical production.” The article discusses more of what is not a balance sheet than what is.
- • Goodwill amortization and the usefulness of earnings, Jennings, R., LeClere, M., & Thompson, R. B. (2001). Financial Analysts Journal, 57(5), 20-28. This study attempts to show from earning data, how goodwill amortization is an indicator of share value for companies, publicly traded during 1993-98. The Financial Accounting Standards Board approved new accounting guidelines, which gets rid of the systematic amortization of goodwill. Instead, the favorableness leans toward reviewing goodwill for damage when the situation calls for it. Jennings, LeClere, and Thompson discovered when earnings are the basis for share valuations, adding goodwill amortization brings along with it turbulence. Before goodwill amortization, distribution of share prices is observed. Their results show that by not including goodwill amortization in the computation of net income, there is no reduction of its usefulness to analysts and investors as a review of share value.
- • How informative are earnings numbers that exclude goodwill amortization?, Moehrle, S. R., Reynolds-Moehrle, J. A., & Wallace, J. S. (2001).. Accounting Horizons, 15(3), 243-255. The FASB or Financial Accounting Standards Board suggested in their original draft of Business Combinations and Intangible Assets that companies’ goodwill not get amortized when reporting share earnings. Only when the nominal dollar amount of the company’s apparent stock worth exceeds the company’s total capital, should it get written down. Moehrle, Reynolds-Moehrle, and Wallace analyze the data of earning not including amortization of intangibles as it relates to the measurement of cash flow from business operations and of income before exceptional items. The study reveals that the explanation of earnings before amortization and the income following “extraordinary items” has no significant difference. Both assessments of earning after extraordinary items and earning before the declining value prove more informative than analyzing the flow of cash from operations.
- Amortization of advertising expenditures in the financial statements, Peles, Y. (1970). Journal of Accounting Research, 128-137. Peles discusses how the numbers for some companies show that the accounting technique used to treat advertising expenditures has a massive impact on the earnings reports and the company’s financial position. A majority of accounts charge advertising expenses to the present spending, which creates a 100 percent total amortization rate. Peles continues to discuss how the assets of advertising are categorically made part of goodwill — undefined residual — but no one is sure of how the intangible asset originated and how to report it.
- • Determinants of goodwill amortization period, Hall, S. C. (1993). Journal of Business Finance & Accounting, 20(4), 613-621. Hall discovers that the period for which goodwill is amortized correlates to the size of the company. The author also reports that the goodwill amortization period has something to do with the company’s leverage, especially when only limitations from debt agreements get listed that rely partially on goodwill accounting.
- • Is the selection of the amortization period for goodwill a strategic choice?, Henning, S. L., & Shaw, W. H. (2003). Review of Quantitative Finance and Accounting, 20(4), 315-333. Henning and Shaw investigate whether the decision of amortization duration for purchased goodwill is a sign of the earning amounts the following acquisition because shorter amortization lives could influence a dilution in income. The study also shows a correlation between stock performance and post-acquisition income. Amortization life predicts a successful acquisition in stock performance down the line and changes in earnings.
- • Efficient gain and loss amortization and optimal funding in pension plans, Owadally, M. I., & Steven, H. (2004). North American Actuarial Journal, 8(1), 21-36. The gains and losses arising consequently from identically distributed and independent rates of return from an investment should be indirectly and proportionally amortized to spread the gains and losses, which is more efficient.
- The value relevance of goodwill impairment loss: while the market discounts the importance of goodwill amortization, it does not disregard goodwill impairment loss as …, Duangploy, O., Shelton, M., & Omer, K. (2005). Bank Accounting & Finance, 18(5), 23-29. According to the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards, all companies are required to perform a yearly goodwill impairment test to see if goodwill, which is assumed value that should add value to the company’s assets, has suffered a drop in worth. The new impairment test is based on the concept that not all goodwill drops in value. Compared to goodwill amortization, which was a small charge over time, goodwill impairment loss can be comparatively extensive. Duangploy, Shelton, and Omer in this article ask if the noncash charge of impairment loss should be ignored or considered into a stock’s value in the market.
- Amortization of Intangibles: A Reassessment of the Tax Treatment of Purchased Goodwill, Gregorcich, M. J. (1975). The Tax Lawyer, 251-288. Gregorcich says that since prohibition, goodwill has been amortizable. However, the authors believe the idea of amortizing intangibles, regardless of their undefined useful life, should now be considered. In the 1960s, intangibles, along with goodwill were reconsidered for accounting. Gregorcich feels laws in place regarding the amortization of intangibles could be the utmost meaningful action to occur in taxation which would have a significant impact on business acquisitions.
- Amortization of Intangible Assets: 197 of the Internal Revenue Code Settles the Confusion, The, Hammond, C. L. (1994)., The. Conn. L. Rev., 27, 915. Hammond shows that the one problem with past tax regime for intangibles was how it created many lawsuits regarding the acknowledgment of intangible assets and their determined useful lives.
- Goodwill and amortization: Are they value relevant?, Churyk, N. T., & Chewning Jr, E. G. (2003). Academy of Accounting and Financial Studies Journal, 7(2), 57. The Financial Accounting Standards Board suggested several ways to treat goodwill following an acquisition. They established a new accounting principle which doesn’t mean the requirement of goodwill amortization. Instead, there should be a periodic analysis done to determine the impairment of goodwill. The implication presented says there is an “indefinite economic life” of goodwill. This study investigates if equity markets consider goodwill an economic resource and whether goodwill amortization correlates to a company’s market value.