What Does Amortize Mean in Accounting?

Amortization is an accounting method that systematically reduces the value of an asset or a loan over a period of time. This process aims to match the cost of an asset with the revenues it helps generate, or to allocate loan repayments across its term. It ensures that the financial statements accurately reflect the consumption of an asset’s economic benefits or the gradual repayment of a debt.

Amortizing Intangible Assets

Intangible assets are non-physical assets that hold long-term economic value for a business. Examples include patents, copyrights, trademarks, customer lists, software development costs, and franchise agreements. These assets are amortized because their value diminishes over their finite useful life, similar to how tangible assets like machinery depreciate.

The most common method for calculating amortization for intangible assets is the straight-line method, which spreads the asset’s cost evenly over its estimated useful life. For instance, if a company acquires a patent for $100,000 with a useful life of 10 years, the annual amortization expense would be $10,000.

Goodwill, which arises when a business is purchased for more than the fair value of its identifiable net assets, is not amortized under U.S. Generally Accepted Accounting Principles (GAAP). Instead, goodwill is tested at least annually for impairment, meaning its value is assessed to determine if it has decreased. For tax purposes, however, many acquired intangible assets, including goodwill, are amortized over a mandatory 15-year period under Section 197, regardless of their actual useful life.

Amortizing Loans and Debt

Amortization also applies to financial obligations such as loans and bonds, where it refers to the process of paying down debt over time through regular installments. An amortization schedule details how each payment is divided between principal and interest over the loan’s term. Common examples include mortgages, car loans, and business loans.

Early in a loan’s life, a larger portion of each payment typically goes towards interest, because the outstanding loan balance is higher. As the loan balance decreases with each payment, a progressively larger portion is applied to the principal. This gradual shift ensures the loan is fully repaid by its maturity date.

Bond premiums or discounts are also amortized to adjust the bond’s carrying value and the interest expense recognized over its life. When a bond is issued at a premium (above face value), the premium is amortized to reduce interest expense over time. Conversely, if a bond is issued at a discount (below face value), the discount is amortized, which increases the recognized interest expense over the bond’s term.

How Amortization Impacts Financial Statements

Amortization impacts a company’s financial statements. On the income statement, amortization is recorded as an expense, which reduces a company’s net income. This expense reflects the cost of using the intangible asset or the adjustment to interest for bonds during the accounting period.

On the balance sheet, accumulated amortization is presented as a contra-asset account, directly reducing the carrying value of the intangible asset. This means the net book value of the asset decreases over time until it reaches zero or its estimated residual value.

Amortization is considered a non-cash expense. While it reduces reported profit, it does not involve an actual outflow of cash in the current period. For cash flow analysis using the indirect method, amortization expense is added back to net income in the operating activities section.