Explaining Amortization in the Balance Sheet

For example, a company often must often treat depreciation and amortization as non-cash transactions when preparing their statement of cash flow. Without this level of consideration, a company may find it more difficult to plan for capital expenditures that may require upfront capital. In general, the word amortization means to systematically reduce a balance over time. In accounting, amortization is conceptually similar to the depreciation of a plant asset or the depletion of a natural resource. Amortization refers to the process of paying off a debt through scheduled, pre-determined installments that include principal and interest.

• Amortization helps businesses and investors understand and forecast their costs over time.
• This variation can result in significant differences between the amortization expense recorded on the company’s book and the figure used for tax purposes.
• The IRS has schedules that dictate the total number of years in which to expense tangible and intangible assets for tax purposes.
• The amortization base of an intangible asset is not reduced by the salvage value.

It is often used with depreciation synonymously, which theoretically refers to the same for physical assets. The Canada Revenue Agency requires companies to amortize the costs of long-term assets over the lifetime of their use to claim the capital cost allowance. Some examples of fixed or tangible assets that are commonly depreciated include buildings, equipment, office furniture, vehicles, and machinery. A good example of how amortization can impact a company’s financials in a big way is the purchase of Time Warner in 2000 by AOL during the dot-com bubble.

Is It Better to Amortize or Depreciate an Asset?

However, it will be amortized at the end of each year for 5 years on a straight-line basis ie. 200,000 will be recorded as an expense and will be written-off from the amount of software each year for 5 consecutive years. Revenue is also called net sales because discounts and deductions from returned merchandise may have been deducted. To understand the accounting impact of amortization, let us take a look at the journal entry posted with the help of an example. With this, we move on to the next section which clears out if amortization can be considered as an asset on the balance sheet.

The term amortization can also refer to the completion of that process, as in “the amortization of the tower was expected in 1734”. Under the process of amortization, the carrying value of the intangible assets on the balance sheet is incrementally reduced until the end of the expected useful life is reached. The usual shortcut for calculating EBITDA is to start with operating profit, also called earnings before interest and taxes (EBIT), then add back depreciation and amortization.

Examples of Intangible Assets

Accrual accounting permits companies to recognize capital expenses in periods that reflect the use of the related capital asset. In other words, it lets firms match expenses to the revenues they helped produce. The above profit & loss extract shows 200,000 has been recorded as amortization expenses for the period Jan-Dec 20×1.

It reduces the earnings before tax and, consequently, the tax that the company will have to pay. For the machine purchased at $10,000, if we assume a 30% amortization rate, the amortization expense in the first year would be $3,000. Since the amounts being spread out are greater in the first few years after the equipment purchase, they further reduce a company’s earnings before tax during that period. In the prior section, we went over intangible assets with definite useful lives, which should be amortized. If an intangible asset is anticipated to provide benefits to the company firm for greater than one year, the proper accounting treatment would be to capitalize and expense it over its useful life. Next, the amortization expense is added back on the cash flow statement in the cash from operations section, just like depreciation.

Example of Amortization Expense

Negative amortization is particularly dangerous with credit cards, whose interest rates can be as high as 20% or even 30%. In order to avoid owing more money later, it is important how to add expenses and receipts to an invoice to avoid over-borrowing and to pay off your debts as quickly as possible. Accountants use amortization to spread out the costs of an asset over the useful lifetime of that asset.

When amortizing loans, a gradually escalating portion of the monthly debt payment is applied to the principal. When amortizing intangible assets, amortization is similar to depreciation, where a fixed percentage of an asset’s book value is reduced each month. This technique is used to reflect how the benefit of an asset is received by a company over time. Another difference is the accounting treatment in which different assets are reduced on the balance sheet.