If you've ever had a car loan or mortgage to pay off, you've probably already heard of the term amortization. Paying off a debt (like a car or home loan) in regular installments over time is one form of amortization, but when it comes to your small business accounting, it takes on a bit of a different meaning. And it all centers around your company's assets.
Accounting for Assets Over Time
The main purpose of amortization in accounting is to spread out the cost of certain assets held by your company over a specific period of time. Expensing assets in a systematic way like this is one of the keys of the accrual basis of accounting.
You may be thinking this all sounds quite similar to another concept in accounting: depreciation. Yes, amortization and depreciation are similar, but there's a key difference between the two. Where depreciation deals with spreading out the cost of a tangible asset over time (things like equipment used to make your product, or a company vehicle), amortization deals with intangible assets.
Intangible assets are things that your company owns or that bring it profit, but don't take up any physical space. This encompasses things like intellectual property (think: patents, trademarks, branding/logos).
The time period involved in amortization is also important to note. It corresponds to your asset's useful life—or to be more precise, its useful economic life. This is the length of time during which the asset can effectively be used to bring your company profit.
Putting It On the Books
So how does amortization show up on your financial statements? The two main financial statements that amortization impacts are affected are your balance sheet and your income statement. When amortization is recorded on your company's books, you reduce the asset's carrying amount (also known as the "book value") on the balance sheet and add it as an expense to the income statement.
Let's look at an example. Say your company pays $1 million for a patent (an intangible asset), and the patent's useful life is 10 years. This means that for each of those 10 years, you will record $100,000 in amortization expense for the patent in your financial statements.
As we can see in the example above, amortization allocates (or prorates) the cost of an intangible asset over its useful life in a highly regular way.
If your company holds intangible assets like copyrights or trademarks, it's a good idea to check in with a legal or accounting professional and consult your local tax laws about how to properly amortize these assets—because as always, this post is intended for general informational purposes only.