Amortization Expense

What is an Amortization Expense?

Definition: Amortization expense is the write-off of an intangible asset over its expected period of use, which reflects the consumption of the asset. This write-off results in the residual asset balance declining over time. The amount of this write-off appears in the income statement, usually within the “depreciation and amortization” line item.

Amortization is the cost allocated to intangible assets over their useful lives. This process is similar to the depreciation process for fixed assets except alternative and accelerated expense methods are not normally allowed. The amortization process requires the use of the straight-line method unless the company can demonstrate how and why another preferred method is more appropriate.

What Does Amortization Expense Mean?

Intangible assets are non-physical assets that are used in the operations of a company. Some examples include patents, copyrights, and licenses. The assets are unique from physical fixed assets because they represent an idea, contract, or legal right instead of a physical piece of property.

These assets benefit the company for many future years, so it would be improper to expense them immediately when they are purchase. Instead, intangible assets are capitalized when purchased and reported on the balance sheet as a non-current asset. In order to agree with the matching principle, costs are allocated to these assets over the course of their useful life.

It’s important to remember that not all intangible assets have identifiable useful lives. Unlike physical assets, intangible assets don’t get worn out. They expire. Some intangibles don’t expire, however. Take a franchise license for example. It expires every year and can be renewed annually without a renewal limit. This situation creates an asset that never expires as long as the franchisee continues to perform in accordance with the contract and renews the license. In this case, the license is not amortized because it has an indefinite useful life.

The accounting for amortization expense is a debit to the amortization expense account and a credit to the accumulated amortization account. The accumulated amortization account appears on the balance sheet as a contra account, and is paired with and positioned after the intangible assets line item. In some balance sheets, it may be aggregated with the accumulated depreciation line item, so only the net balance is reported.

Amortization is almost always calculated on a straight-line basis. Accelerated amortization methods make little sense, since it is difficult to prove that intangible assets are used more quickly in the early years of their useful lives.

Amortization is most commonly used for the gradual write-down of intangible assets. Examples of intangible assets are:

  • Broadcast licenses
  • Copyrights
  • Patents
  • Taxi licenses
  • Trademarks

How to Calculate Amortization Expense

With the above information, use the amortization expense formula to find the journal entry amount.

Amortization Expense = (Initial value – Residual value) / Lifespan

Subtract the residual value of the asset from its original value. Divide that number by the asset’s lifespan. The result is the amount you can amortize each year. If the asset has no residual value, simply divide the initial value by the lifespan.

Record amortization expenses on the income statement under a line item called “depreciation and amortization.” Debit the amortization expense to increase the asset account and reduce revenue. Credit the intangible asset for the value of the expense.

Example

ABC Corporation spends $40,000 to acquire a taxi license that will expire and be put up for auction in five years. This is an intangible asset, and should be amortized over the five years prior to its expiration date. The annual journal entry is a debit of $8,000 to the amortization expense account and a credit of $8,000 to the accumulated amortization account.

The rate at which amortization is charged to expense in the example would be increased if the auction date were to be held on an earlier date, since the useful life of the asset would then be reduced.

Accounting Steps

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. 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. The offsetting entry is a balance sheet account, accumulated amortization, which is a contra account that nets against the amortized asset.

Amortization and Taxes

The Internal Revenue Service requires companies to report their amortization expenses on a separate schedule when they file their income tax returns. The proper form to use is IRS Form 4562. Complete Part VI and submit it with your tax return. It is not necessary to file a Form 4562 if there are no new amortizable expenses for the year and there is no depreciation to report. Amortization begun in a previous year is simply reported on the return itself under either “Other Expense Line” or “Other Deduction.”

What is the Difference between Depreciation and Amortization?

Amortization is similar to depreciation. Depreciation is used to spread the cost of long-term assets out over their lifespans. Like amortization, you can write off an expense over a longer time period to reduce your taxable income. However, there is a key difference in amortization vs. depreciation.

The difference between amortization and depreciation is that depreciation is used on tangible assets. Tangible assets are physical items that can be seen and touched. For example, vehicles, buildings, and equipment are tangible assets that you can depreciate.

You must use depreciation to allocate the cost of tangible items over time. You cannot amortize a tangible asset. Likewise, you must use amortization to spread the cost of an intangible asset out in your books.

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