Amortization is an accounting practice in which companies spread the cost of intangible assets over a period of time. It is similar to the process of depreciation that accountants use for tangible assets. Amortization is often used for assets, such as patents and copyrights, which have a defined life over which they will provide profit to the holder.
Definition of Amortization
Accountants amortize a purchase by accounting for part of the price of the asset each year of its useful life. An accountant must determine the period over which the asset will generate revenue for the company, which is called useful life. If the asset will have resale, or salvage, value at the end of that period, then he must subtract that value from the price to find the total amount that he must amortize. If it has no salvage value, as is the case with a copyright that expires after a certain time period, then the accountant must amortize the full price. How much of the cost is accounted in each year depends on the method of amortization.
There are three methods of amortization. The simplest is straight-line, in which the purchase price of the asset is divided by its useful life to yield an amortization amount per period. For an asset with five years of useful life, for example, the company would report a cost of one fifth of the purchase price each year for five years. Accelerated amortization is the second method. This has several variations, but all rely on some formula to calculate amortization such that more of the purchase price is reported in earlier years than in later years. Finally, the unit production method scales the amortization to how much the asset was used in a particular year. This is less useful for intangible assets than for equipment since an intangible asset can be used an indeterminate number of times within its useful life.
Reasons to Amortize
The practice of amortization is widespread because it gives a realistic account of the net cost of a purchase. If amortization were not used, the net assets of a company would fluctuate wildly. A company that needed to refit every five years, for example, would show low profits in refit years. This could frighten investors, who might not realize that the costs were expected and that the high profits in the next four years were a direct result of the purchases. Amortization matches the cost of an asset with the profits that it generates, giving a more accurate representation of a company's profitability.
Investors can be misled by amortization in the years when companies make large purchases. If a company buys an expensive copyright, it may expect to profit from its acquisition for years to come, but it must pay the entire cost upfront. This means that a company's balance sheet might give the impression that it has enough money to cover its debts when in reality it is on the verge of insolvency.