What is Amortization Expenses: A Guide for Business Owners

Business owners must allocate the cost of the assets over their useful life. Allocating expenses over a period will result in a more realistic reflection of the financial position of the company.

The assets that a business can allocate over a period can be tangible or intangible.

Allocation of the cost of intangible business assets is known as amortization. In this blog post, we will delve more into the topic.

Amortization Expenses: An Overview

Amortization expenses allocate the cost of intangible assets over the life of the asset. Intangible assets include assets that are not in physical form. Examples of intangible assets that can be amortized by outsourced bookkeeping service providers include patents and trademarks.

An important thing to remember regarding amortization costs is that only intangible assets with a limited life can be amortized. Intangible assets such as goodwill that have an indefinite life cannot be amortized. Moreover, the IRS sets a limit on the expense that can be amortized in a year. The limit is known as capital cost allowances.

Amortization expenses are recorded in the income statement of the company. In addition, the expenses reduce the book value of the amortized asset by the same amount on the balance sheet.

Examples of Amortization Expenses

Accountants amortize the intangible asset until the end of its useful life. The amount is recorded in the financial statement until the cost of the asset is fully amortized over its life.

An example will help in understanding the concept of amortization expense.

Suppose that a company owns a patent valued at $250,000 that expires in 10 years. Accountants can calculate the amortization expenses using two methods. To calculate the amortization expense, the patent value is divided by the patent life as shown below.

$250,000 / 10 = $25,000

The following table shows how the amortization expense reduces the value of the intangible asset over its life.

You can see in the above table that the amortization expense remains the same each period. This expense will be recorded in the income statement of the company when the financial statement is prepared.

You can also see that the book value of the intangible asset is reduced each year. The amortized value of the asset becomes zero at the end of the useful life. In the above table, you can see that the amortized value that is calculated by subtracting the net book value during a period with the amortization expense is zero at the tenth year when the patent ends.

Difference Between Amortization, Depreciation, and Depletion

The three different methods for calculating the asset value include amortization, depreciation, and depletion. The main difference between the two methods depends on the type of asset that is expensed over a period.

Amortization expenses involve the allocation of the cost of intangible assets – patents, trademarks, franchise agreements, and copyrights. The expense is calculated using the single line balance method. It reduces the net profit in the income statement and the value of the amortized asset on the balance sheet.

In contrast, depreciation expenses involve the allocation of the cost of the tangible assets – office furniture, computer equipment, vehicles, and machinery. The expense is calculated using different methods including the single line balance method, declining method, the sum of years’ digit method, and modified accelerated cost recovery system (MACRS).

Depletion is similar to depreciation and amortization which is valid for natural resources. Accountants calculate depletion expenses for assets such as oil, timber, agricultural products, and minerals.

Assets that are amortized or depleted don’t have any salvage value. Contrarily, assets that are depreciated have a salvage value that is accounted for when calculating the depreciation expenses.

The term amortization can also be used for the loan but in a different context. Accountants create an amortization schedule that shows the payment of loans such as mortgage loans over a period.

How Amortization Expenses are Recorded by Outsourced Bookkeepers?

Amortization expenses are recorded through debit and credit entries in the journal. The amortization expense is debited and a contra asset accumulated depreciation is credited. The following journal entry is made when recording amortization expenses during a period.

Amortization Expenses (Debit)

Accumulated Amortization Expenses (Credit)

Let’s suppose that the amortization expense of a patent value is $30,000. The amortization expense can be recorded by making the following entry in the journal.

Amortization Expenses (Debit) $30,000

Accumulated Amortization Expenses (Credit) $30,000

The amortization expense of $30,000 will be entered into the income statement. It will reduce the net profit reported in the financial statement. In addition, amortization expense will reduce the book value of the asset by $30,000.

The following shows the excerpts from the income statement and balance sheet of a fictional company that shows how the amortization expenses will be recorded in the financial statements.

Conclusion

Amortization, depreciation, and depletion are all non-cash expenses. The expenses are not recorded in the cash flow statement. Some accountants use the terms amortization and depreciation interchangeably, which is wrong.

The key difference between the three is the type of asset that is expensed over its useful life. The allocation of intangible assets is known as amortization. In contrast, the allocation of tangible assets is known as depreciation. The act of allocating the value of natural resources is called depletion.

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