What is amortization?

Amortization (definition)

Amortization is the depreciation of intangible assets for bookkeeping and tax purposes. It can also refer to the reduction of a loan over time.

Amortization is how a business records the purchase of an intangible asset in its accounting records and on its tax returns. The purchase price is written off gradually over the asset’s useful life. Amortization can also refer to paying down a debt over time.

Automate amortization with Xero.

What is asset amortization vs loan amortization

When a business buys an asset, it typically writes off the cost over time rather than all at once. For physical (or tangible) assets, this process is called depreciation. For intangible assets like patents, trademarks, copyrights or goodwill, the process is called amortization.

Paying down a debt is referred to as loan amortization. While it’s important to understand loan amortization, this glossary definition deals with asset amortization.

Why asset amortization matters

Amortization gives businesses a better sense of their profit and loss from year to year. Writing off the full value of an asset at the time of purchase would make profits look artificially low for that year.

Say a business buys a 20-year patent for $100,000. If it wrote off the full value of the patent straight away, its profit would dip $100,000 in that year alone. In subsequent years, profits would look a lot higher even though the business is still getting value from the asset. Amortizing the asset by $5000 every year for 20 years better distributes the cost so the business can see its profitability from year to year.

How amortization works

The business records the full value of the asset on its balance sheet at the time of purchase. At the end of every year, it amortizes that asset to reflect its loss of value over time.

The amount amortized is reflected on the balance sheet and is recorded as an expense on the income statement. Recording amortization as an expense helps to lower taxes.

This process continues throughout the useful life of the asset. So if it’s a patent, it continues until the patent expires.

How to calculate amortization

Amortizing assets is complicated and the formula may change depending on the amortization method being used. The process starts by recording the purchase price of the asset and then amortizing a certain amount each year. The amount amortized depends on:

• the value of the asset
• the asset’s lifespan (this number may be set by the tax office)
• the amortization method being used (which is also subject to rules)

Some accounting software will automate these calculations but the input must be correct and compliant with rules set by the IRS.

Consult with an accountant or bookkeeper to avoid costly mistakes. You can find one in the Xero advisor directory.

Four common methods of amortization

As noted, the IRS sets rules about which amortization methods can be used in given situations. Always consult with an expert before choosing a method.

1. Straight-line amortization: An equal portion of the asset's value is amortized each year of its useful life. For example, a $150,000 asset with a 15-year lifespan would be amortized $10,000 per year.
2. Declining balance method: The asset is amortized more during the early years of its life and by lower amounts in subsequent years. For example, if the asset costs $10,000 the business might amortize at a rate of 30% per year. That would equate to $3000 the first year. The following year, the remaining value would be $7000, so 30% amortization would be $2100. This pattern would continue until the asset is fully amortized.
3. Double declining balance method: This is a form of declining balance where the rate of amortization is set in a certain way. Specifically, the rate is calculated by dividing the number 2 by the useful life of the asset. So an asset with a useful life of 5 years would be amortized at 40% (2 / 5 x 100 = 40%) per year.
4. Annuity method: The asset is amortized according to how much money it earns the business in a given year. This requires a model for figuring out the lifetime income the asset will generate. As a result, it’s the most complex of all the methods.

Amortization vs depreciation

Amortization and depreciation work the same. Amortization is the word used for intangible assets, which are non-physical things like patents, copyrights and licences. Depreciation is for tangible assets, which are physical things like vehicles, tools, and equipment.

See related terms

Intangible assets

Assets

More terms