Amortization

Understanding Amortization in Accounting

What Does Amortization Mean?

Amortization is an important word in accounting and business. It means spreading the cost of something over many years. When a company amortizes something, it divides a big cost into smaller parts and writes down a little bit each year.

The word comes from an old French word that means "to kill" or "to make something die." In accounting, you are slowly "killing" the value of an asset over time.

What Are Intangible Assets?

To understand amortization, we first need to understand intangible assets. "Intangible" means you cannot touch it. It is not physical.

A table is a physical asset. You can touch it. You can see it.

But some valuable things are not physical. You cannot touch them, but they are still worth money. These are intangible assets.

Examples of intangible assets:
• Patents: Legal rights to an invention
• Trademarks: Special names or logos for products
• Copyrights: Rights to books, music, or art
• Software: Computer programs
• Customer lists: Information about customers
• Licenses: Permission to do certain business activities

Why Do Companies Amortize Intangible Assets?

Let's look at an example. A technology company buys a patent for $100,000. The patent lets them make a special kind of phone. The patent is good for 10 years.

The company paid $100,000 today. But they will use this patent for 10 years. It would not be fair to show all the cost in just one year. The patent helps the company make money for 10 years.

So the company uses amortization. They divide $100,000 by 10 years. Each year, they write down $10,000 as an expense. This is called "amortization expense."

Year 1: Amortization expense = $10,000
Year 2: Amortization expense = $10,000
Year 3: Amortization expense = $10,000
...and so on for 10 years.

This way, the cost matches the time when the company uses the asset. This is more accurate and fair.
How Does Amortization Work?

The basic formula is simple:
Amortization per year = Total cost ÷ Number of useful years

Let's look at more examples:
Example 1: Software
A restaurant buys accounting software for $12,000. The software will be useful for 4 years.
Amortization per year = $12,000 ÷ 4 = $3,000
Each year, the company shows $3,000 as amortization expense.

Example 2: Trademark
A clothing company buys a famous brand name for $50,000. They can use this trademark for 25 years.
Amortization per year = $50,000 ÷ 25 = $2,000
Each year, the company shows $2,000 as amortization expense.

Example 3: Copyright
A publishing company buys the copyright to a popular book for $30,000. The copyright lasts for 15 years.
Amortization per year = $30,000 ÷ 15 = $2,000
Each year, the company shows $2,000 as amortization expense.

What Happens on the Balance Sheet?
The balance sheet is a financial document. It shows what a company owns and what it owes.
When a company first buys an intangible asset, it appears on the balance sheet at full cost.
Each year, as the company amortizes the asset, the value on the balance sheet gets smaller.

Let's use the patent example again:
• Start (Year 0): Patent value = $100,000
• End of Year 1: Patent value = $90,000 (because $10,000 was amortized)
• End of Year 2: Patent value = $80,000
• End of Year 3: Patent value = $70,000
• End of Year 10: Patent value = $0
The asset value decreases until it reaches zero.

Amortization vs. Depreciation

Amortization and depreciation are very similar. Both spread costs over time. But there is one important difference:

Depreciation is for physical assets - things you can touch:
• Buildings
• Machines
• Vehicles
• Computers (the physical machine)
• Furniture

Amortization is for intangible assets - things you cannot touch:
• Patents
• Trademarks
• Copyrights
• Software (the program, not the computer)
• Licenses

Both follow the same idea: big costs are divided over many years.

Why Is Amortization Important?

It shows true profit. Without amortization, a company might look very unprofitable in the year they buy an asset. Then they might look too profitable in later years. Amortization spreads the cost fairly.
It helps with taxes. Amortization is a business expense. Expenses reduce profit. Lower profit means lower taxes. So amortization can help companies pay less tax legally.

It helps investors understand. Investors look at company financial statements. Amortization helps them see the real costs of doing business. They can make better decisions about investing.
It follows accounting rules. Accounting has important rules called "matching principle." This principle says costs should match the time when you earn money from them. Amortization follows this rule.

Not All Intangible Assets Are Amortized

Some intangible assets last forever. These are not amortized.
Goodwill is a special intangible asset. It appears when one company buys another company for more than the value of its assets. Goodwill represents the reputation and customer relationships of the business. Because goodwill can last forever, it is not amortized.
Trademarks with unlimited life are also not amortized. Some trademarks can be renewed forever. If a company plans to renew forever, they don't amortize the trademark.
Instead, these assets are "tested" each year. If their value goes down, the company writes down the loss. This is called "impairment," not amortization.

Real-World Example
Let's look at a complete example with a small company.
Green Gardens Company makes gardening tools. In 2024, they buy three intangible assets:
1. A patent for a new tool design: $60,000 (useful for 12 years)
2. Software for managing inventory: $24,000 (useful for 6 years)
3. A license to sell products online: $18,000 (useful for 9 years)
Total cost: $60,000 + $24,000 + $18,000 = $102,000

Amortization each year:
• Patent: $60,000 ÷ 12 = $5,000 per year
• Software: $24,000 ÷ 6 = $4,000 per year
• License: $18,000 ÷ 9 = $2,000 per year
Total amortization expense per year: $5,000 + $4,000 + $2,000 = $11,000
Green Gardens will show $11,000 as amortization expense each year (until each asset is fully amortized)
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Conclusion

Amortization is a key concept in accounting. It helps companies spread the cost of intangible assets over the years they use them. This gives a more accurate picture of business expenses and profit.
When you see "amortization" in a financial statement, you now know what it means. The company is slowly writing off the cost of valuable things they own but cannot touch - like patents, trademarks, or software.
Understanding amortization helps you read financial statements better. It helps you understand how businesses manage their money and report their performance.
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Comprehension Questions
1. What does "intangible" mean? Give two examples of intangible assets.
2. A company buys a patent for $80,000. The patent lasts 20 years. How much amortization expense does the company show each year?
3. What is the difference between amortization and depreciation?
4. Why do companies use amortization? Give at least two reasons.
5. Green Gardens Company amortizes software over 6 years. In which year will the software value become zero on the balance sheet?
6. True or False: All intangible assets must be amortized. Explain your answer.
7. What is "goodwill"? Is it amortized?
8. A restaurant buys accounting software for $15,000. It will use the software for 5 years. What is the amortization expense each year?
9. How does amortization help a company show "true profit"?
10. Imagine you own a small business. You want to buy a trademark for $40,000. If you amortize it over 10 years, how would this affect your financial statements each year?




Answers to Amortization Questions:
1. What does "intangible" mean? Give two examples of intangible assets.
- "Intangible" means you cannot touch it. It is not physical.
- Examples: patents, trademarks, copyrights, software, customer lists, licenses (any two of these)
2. A company buys a patent for $80,000. The patent lasts 20 years. How much amortization expense does the company show each year?
- $4,000 per year ($80,000 ÷ 20 = $4,000)
3. What is the difference between amortization and depreciation?
- Depreciation is for physical assets (things you can touch like buildings, machines, vehicles). Amortization is for intangible assets (things you cannot touch like patents, trademarks, software).
4. Why do companies use amortization? Give at least two reasons.
- It shows true profit
- It helps with taxes
- It helps investors understand the business
- It follows accounting rules (matching principle) (Any two of these answers is correct)
5. Green Gardens Company amortizes software over 6 years. In which year will the software value become zero on the balance sheet?
- At the end of Year 6 (or after 6 years)
6. True or False: All intangible assets must be amortized. Explain your answer.
- False. Some intangible assets like goodwill and trademarks with unlimited life are not amortized. They last forever and are tested for impairment instead.
7. What is "goodwill"? Is it amortized?
- Goodwill appears when one company buys another company for more than the value of its assets. It represents reputation and customer relationships. No, it is not amortized because it can last forever.
8. A restaurant buys accounting software for $15,000. It will use the software for 5 years. What is the amortization expense each year?
- $3,000 per year ($15,000 ÷ 5 = $3,000)
9. How does amortization help a company show "true profit"?
- Without amortization, a company would show a very big expense in the year they buy an asset, making profit look too low. Then profit would look too high in later years. Amortization spreads the cost fairly over all the years the asset is used, giving a more accurate picture of profit each year.
10. Imagine you own a small business. You want to buy a trademark for $40,000. If you amortize it over 10 years, how would this affect your financial statements each year?
- Each year, the business would show $4,000 as amortization expense on the Income Statement ($40,000 ÷ 10 = $4,000). On the Balance Sheet, the trademark value would decrease by $4,000 each year until it reaches zero after 10 years.