Amortization is an accounting practice whereby expenses or charges are accounted for as the useful life of the asset is consumed or used rather than at the time they are incurred. Amortization includes such practices as depreciation, depletion, write-off of intangibles, prepaid expenses and deferred charges. By amortizing an asset or liability the value of the item is reduced gradually over time by some periodic amount (i.e., via installment payments). In the case of an asset, it involves expensing the item over the “life” of the item—the time period over which it can be used. For a liability, the amortization takes place over the time period that the item is repaid or earned. Amortization is essentially a means to allocate categories of assets and liabilities to their pertinent time period.
The key difference between depreciation and amortization is the nature of the items to which the terms apply. The former is generally used in the context of tangible assets, such as buildings, machinery, and equipment. The latter is more commonly associated with intangible assets, such as copyrights, goodwill, patents, and capitalized costs (e.g., product development costs).
On the liability side, amortization is commonly applied to deferred revenue items such as premium income or subscription revenue (wherein cash payments are often received in advance of delivery of goods or services), and therefore must be recognized as income distributed over some future period of time.
Amortization is a means by which accountants apply the period concept in accrual-based financial statements: income and expenses are recorded in the periods affected, rather than when the cash actually changes hands. The importance of spreading transactions across several periods becomes clearer when considering long-lived assets of substantial cost. Just as it would be inappropriate to expense the entire cost of a new facility in the year of its acquisition since its life would extend over many years, it would be wrong to fully expense an intangible asset only in the first year. Intangible assets such as copyrights, patents, and goodwill can be of benefit to a business for many years, so the cost of accruing such assets should be spread over the entire time period that the company is likely to use the asset or generate revenue from it.
The periods over which intangible assets are amortized vary widely, from a few years to as many as 40 years.
The costs incurred with establishing and protecting patent rights, for example, are generally amortized over 17 years. The general rule is that the asset should be amortized over its useful life. Small business owners should realize, however, that not all assets are consumed by their use or by the passage of time, and thus are not subject to amortization or depreciation. The value of land, for example, is generally not degraded by time or use. In fact, the value of land often increases with time.
This applies to intangible assets as well; trademarks can have indefinite lives and can increase in value over time, and thus are not subject to amortization.
The term amortization is also used in connection with loans. The amortization of a loan is the rate at which the principal balance will be paid down over time, given the term and interest rate of the note. Shorter note periods will have higher amounts amortized with each payment or period.