Running a small business means you're no stranger to the financial juggling of your expenses, assets, and cash flow. There are many instances where companies need to take out a loan or pay off assets over multiple accounting periods. In such cases, you may find amortization is a beneficial accounting method. 

• What is amortization in simple terms?
• Intangible assets
• Loans
• Depreciation vs. amortization
• What is an example of amortization
• Scheduling period payments
• How do you calculate amortization?
• Straight-line method
• Is amortization a good or bad accounting technique?
• How amortization applies to your small business
• FAQs

What is amortization in simple terms?

Amortization is an accounting term used to describe the act of spreading out the expense of a loan or intangible asset over a specified period with incremental monthly payments. 

You can use this accounting function to help cover your operating costs over time while still being able to utilize and make money off the asset you’re paying off.

There are typically two types of amortization in accounting — one for loans and one for intangible assets.

Intangible assets

Assets refer to something that creates earnings or brings value to a person or company. 

Tangible assets refer to things that are physically real or perceptible to touch, such as equipment, vehicles, office space, or inventory.

Intangible assets refer to things that cannot be physically touched but are still real and have value. Examples include: 

• Government licenses
• Patents
• Incorporation costs
• Customer lists
• Rights to a film
• Copyrights
• Trademarks
• Goodwill 

Loans

Loan amortization is paying off the debt of something over a specified period. A business that uses this option is building equity in the loaned asset while paying off the item at the same time. At the end of the amortized period, the borrower will own the asset outright.

When looking at loans for your company, some things to consider are interest rates, as well as the debt covenants of business loans and the financial leveraging of said debts.

Depreciation vs. amortization: Key Differences

Depreciation and the amortization of assets are similar accounting concepts. However, depreciation refers to spreading the cost of a fixed asset out over time. Tangible assets that depreciate include things like buildings, machinery, and vehicles. Depreciation acknowledges the wear and tear on these assets over time.  

In contrast, amortization is the spreading of costs associated with the life of an intangible asset. The recording of these two types of payments within your financial documents will differ.

To accurately record the periodic payment of an intangible asset, make two entries in the company’s books.

1. Debit to the amortization expense account
2. Credit to the intangible asset account

Depreciation would have a credit placed in the contra asset accumulated depreciation.

What is an example of amortization?

An example of an amortized intangible asset could be the licensing for machinery or a patent for your business.

Suppose a business makes a specific car part for high-end vehicles. The creation of this car part uses patented schematics. Therefore, the company’s intangible asset is this schematic patent.

If the patent runs for 30 years, the company must calculate the total value of the intangible asset to the company and spread its monthly payment over this asset’s life. This accounting function allows the company to use and capitalize on the patent while paying off its life value over time.

Scheduling period payments

If a company is going to amortize something, it will have an attached amortization schedule — which is a table detailing the periodic payments of the loan or asset. 

These regular instalments are generated using an amortization calculator. The allocation of costs over a specified period must be paid in full by the time of the maturity date or deadline.

How do you calculate amortization?

There are easy-to-use schedule calculators that can help you figure out the best loan repayment schedule, taking into account the interest rates and loan type and terms.

One of the trickiest parts of using this accounting technique for a business’s assets is the estimation of the intangible’s service life. Business operators must weigh out the economic value to the company, including the book value, salvage value, and the useful life of the intangible asset.

• Book value: The original cost of an asset minus depreciation.
• Salvage value: Estimate of how much you can sell the asset for once its useful life is over.
• Useful life: Also referred to as the service life, it's an estimate of the amount of time an asset will remain in service or provide benefits to the company.

Many intangibles have a specific legal life attached to them. However, the service life could be considerably shorter than the legal life of an intangible asset. 

Straight-line method

The straight-line method is the equal dispersion of monetary instalments over each accounting period. Generally, this method is the go-to scheduling of payments for businesses. It allows for steady expenses throughout the allocated time.

The expense is calculated as the amortization cost divided by the intangible asset’s estimated useful life, using equally allocated payments. The formula is as follows:

Amortization = (Book Value – Salvage Value) / Useful Life

For instance, imagine your business has purchased a patent for $10,000 which has a useful life of five and no salvage value.

The amortization = $10,000 / 5 = $2,000. This means the annual amortization expense is $2,000. 

Is amortization a good or bad accounting technique?

Amortization is neither good nor bad, but there are certain benefits and downsides to its utilization.

Using this technique to spread your business’s payments of intangible assets or loans over time will reduce taxes for your business for the current tax year. For however long you are using that asset, you are entitled to a deduction on your taxes.

Thus, you could gain a tax break for the entirety of the loan period, benefitting your business for numerous accounting periods. Furthermore, amortization enables your business to possess more income and assets on the balance sheet.

For more information on how to claim intangibles for tax purposes, you can refer to the Government of Canada website.

Furthermore, amortization enables your business to possess more income and assets on the balance sheet.

However, for some, these loan payments happen over a long period — it can be a very slow and drawn-out process. Depending on the payment method used, some payment periods can be quite high, causing cash flow issues within the business.

How amortization applies to your small business

Even though you can't touch an intangible asset, they're still an essential aspect of operating many businesses. Amortization is the affirmation that such assets hold value in a company and must be monitored and accounted for.

Looking for a hands-off approach to amortization? Let QuickBooks accounting keep you organized and keep tabs on all your business finances, including loans and payments. See if QuickBooks is right for your business with our 30-day free trial.

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