Asset amortization is an accounting method used to spread the cost of an intangible asset over its useful life. Asset amortization aims to accurately reflect a company’s financial position, especially when evaluating a merger or acquisition or applying for financing. Understanding this process can help your finance team get a more realistic view of an asset’s value over time. Here’s how asset amortization works, how it differs from depreciation, and some moments in your business life cycle when it makes sense to calculate this indicator.
[Read more: What Is Your Business Worth? Here's How to Find Out]
What is asset amortization?
Asset amortization refers to the accounting practice of spreading the cost of an intangible asset, such as a trademark, patent, or franchise agreement, over the asset’s useful life.
The goal of asset amortization is to match the cost of the asset to the revenue it generates over time. This allows your business to get a more accurate view of its profitability. It also reduces taxable income by recording the expense gradually.
Typically, the amortization of intangible assets follows a straight-line basis. This method expenses the same amount in each period over the asset’s useful life. The basic formula for calculating annual amortization expense is:
(Initial Value−Residual Value) / Useful Life = Annual Amortization Expense
If there is no residual value, divide the initial cost by the useful life.
Amortization vs. depreciation: what’s the difference?
Amortization and depreciation have similar purposes, but amortization applies to intangible assets while depreciation applies to tangible ones. Depreciation applies to equipment, office furniture, vehicles, and other physical items used to run your business.
Amortization and depreciation seem similar at face value, but they originate from different philosophies. “Depreciation is recorded to reflect that an asset is no longer worth the previous carrying cost reflected on the financial statements,” wrote Investopedia. “Amortization is recorded to allocate costs over a specific period.”
Amortization spreads large costs over time, avoiding strain on cash flow, lowering interest expenses, and improving debt ratios.
For example, a vehicle will start to wear out and break down as its mileage increases; it depreciates with use. A design patent has a 14-year lifespan from the date it is granted; it doesn’t age, but its cost can be spread over 14 years.
In more practical terms, the way your small business records depreciation and amortization also differs.
“Amortizing an intangible asset is performed by directly crediting (reducing) that specific asset account. Alternatively, depreciation is recorded by crediting an account called accumulated depreciation, a contra asset account,” wrote Investopedia. “The historical cost of fixed assets remains on a company's books; however, the company also reports this contra asset amount as a net reduced book value amount.”
[Read more: Accounting vs. Financial Planning: Explained]
Why is amortization important for small businesses?
Small business owners need to record amortization on their income sheets and claim it for tax write-offs. The IRS allows businesses to deduct amortized costs over an asset's useful life, reducing taxable income. Failing to properly account for amortization means you’re paying more taxes than you should be.
It also impacts your ability to raise funding when you need to. “Small businesses that fail to account for amortization risk overvaluing their companies by implying value that isn’t really there,” wrote Quickbooks. “Any false company value can adversely affect your financial statements, which can drive away potential investors or financiers.”
Finally, many small businesses struggle with cash flow; asset amortization can help alleviate this challenge. Amortization spreads large costs over time, avoiding strain on cash flow, lowering interest expenses, and improving debt ratios. Spreading out the cost of your intangible assets allows you to smooth out your cash flow and better predict the costs that will impact your profit margin.
By utilizing amortization, small businesses can better understand their financial position, optimize their tax strategy, and make more informed financial decisions for long-term success.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
CO—is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the U.S. Chamber of Commerce, here.
