The fact is that most of a company’s assets, whether tangible or intangible, lose value over time. Those losses are quantifiable, which can have an impact on your business’ accounting practices. When discussing an intangible asset, the process of quantifying gradual losses in value is called amortization.
In accounting, amortizing means spreading out an asset’s cost over the duration of its lifespan. The benefits of recognizing amortization include showing the decrease in the asset’s book value, which can help reduce taxable income for the business in question. Because amortization can be listed as an expense, it can also be used to limit the value of stockholders’ equity.
The term has a second meaning. In the context of a loan (e.g. mortgage), amortization refers to dividing payments into multiple installments consisting of both principle and interest dollars until the item is paid in full. Businesses then record the cost of payments as expenses in their income statements rather than relaying the whole cost at once.
For the purposes of this article, however, we will be focusing on amortization as an aspect of accounting for your small business.
Amortization Versus Depreciation
While amortization and depreciation are similar, they differ in application. Amortization is used for intangible assets, such as patents on inventions, licenses, trademarks, and goodwill in the marketplace.
Depreciation applies to tangible assets that have salvage value. Under the straight-line method of calculating depreciation (which we will explain below), businesses need only to divide the initial cost of an asset by the length of its useful life. Businesses may utilize depreciation to account for payments on tangible assets like office buildings and machines that endure wear and tear over the years.
Accounting for Amortization in Business Accounting
Not only is including amortization and depreciation on a balance sheet important, but failing to do so accurately can actually constitute fraud. After all, the value of an asset is not the same after five years as it was when you purchased it new. Hence, businesses need to take steps to include these values in their income statements and accounting sheets.
The first step business owners should take is to assess the asset’s initial value, as it’s impossible to record amortization correctly without knowing its starting value. Doing this might be as simple as looking at an invoice reflecting what you paid for it. Other times it might require legal assistance, and could be bound by contractual requirements related to the asset in question.
Next, you need to know how much usable life is left in your intangible asset. For example, let’s say you purchased a design patent from another business that registered it in 2015. Since design patents have a life of 15 years, then you could reasonably infer that it has all 15 years of usefulness left.
The third and final piece is determining an asset’s residual value, if any, that you could sell it for after using it. To continue our example: if you plan to sell the aforementioned design patent in five years, then you would be responsible for determining the residual value of its remaining 10-year life.
To calculate amortization, subtract any residual value (i.e. resale value) from your intangible asset’s basis value (i.e. what you paid for it). Divide that number by the number (e.g. months, years) remaining in its useful life. The result is the periodical amount of money that you can amortize. This method is also used by the IRS in calculating any amortization value on Form 4562 (PDF).
When recording amortization on your income sheet, start by debiting the amortization expense. Doing this raises assets while reducing total revenue. Next, credit the intangible asset for the expense’s value. Listed on the other side of the accounting entry, a credit decreases asset value.
Typically, businesses include write-offs from amortization under a line item titled “depreciation and amortization” in their income statements. Don’t be afraid to consult your accountant for tips on your specific needs.
Small businesses that fail to account for amortization risk overvaluing their companies by implying value that isn’t really there. Any false company value can adversely affect your financial statements, which can drive away potential investors or financiers. Save yourself—and your business—the headache and learn to amortize your intangible assets correctly.
For more small business accounting practices, read our article on understanding deferred tax assets and liabilities.