Amortization is an accounting technique that is used to lower the cost value of a finite life or intangible asset through scheduled, incremental charges to income. Like depreciation, amortization spreads the charges out across multiple years so that the costs may be set against the revenues of several years rather than all in one year.
Amortization and depreciation apply the same accounting method to different types of assets. The term “amortization” may also refer to paying down a loan or similar debt.
How It Works
To amortize finite life or intangible assets, you will need the value of the asset and its estimated useful life. The value is then divided by the number of years of estimated useful life, and the result is applied to the accounts during the period of estimated useful life.
Amortization amount = Value of items / Number of estimated years of useful life
How Amortization Relates to EBITDA
EBITDA (earnings before interest, tax, depreciation, and amortization) is a financial measure of a company’s performance. It is often used by financial analysts as a shortcut to estimate the health of a company’s financial decisions.
Because amortization links directly to the formula for EBITDA, it can be used to adjust the EBITDA figures. Large noncash items found in amortization or depreciation figures can be used to bring EBITDA up or down:
EBITDA = Earnings before taxes and interest + depreciation + amortization
Assuming EBTI and depreciation remains constant, but amortization is adjusted, we find that EBITDA can be made to look better or worse, depending on how amortization is calculated.
Example: Amortization of a patent equals $10,000 per year for 10 years or, if calculated against five years $20,000 per year, depreciation expenses are $10,000, and the earnings before taxes and interest (EBTI) are $50,000.
If amortization is taken at 10 years:
EBITDA = $50,000 + $10,000 + $10,000 = $70,000
If amortization is taken at five years:
EBITDA = $50,000 + $10,000 + $20,000 = $80,000
In the second example, the company appears financially stronger than in the first example. It is misleading, however, as the amortization number is based solely on the accountant’s estimate of the reasonable life of the patent.
Examples of Amortization
A few examples of amortization that a small business owner encounter include:
- Patents: Patents are a form of intellectual property that protects how something is made for a set period of time. A factory producing metal shelves for retail stores may take out a patent on a special drill that cuts holes in the shelves for the bolts. They may pay for the full patent in the first year, but the patent will be used over multiple years. Rather than take the expense of the drill patent in year one, they amortize the value of the patent over the likely number of years over which they will use the specialized drill.
- Licensing agreements: A clothing manufacturer enters into a licensing agreement with a celebrity to use her likeness, name, and signature on their clothing line. Because the license is for a set number of years only and licenses an intangible asset, such as the fame of a celebrity, it may be amortized.
- Copyrights: A copyright also protects intellectual property such as photographs, video recordings, written documents, and sound recordings. An author’s copyright may be amortized against the life of the copyright itself providing they believe the item will continue selling during that time period.
Specific examples and guidance on amortization may be found in IRS Section 179, which pertains to amortization and depreciation.
How Does Amortization Differ From Depreciation?
Both amortization and depreciation are accounting terms which refer to how the costs of business assets are apportioned over time. The differences in the two terms lies in the asset category. Amortization refers to intangible assets while depreciation refers to tangible assets.
A patent, although it is a document issued by the government, is an idea, concept, or method. Therefore, it’s an intangible asset. Its value lies in how it is applied to the company rather than the intrinsic value in the item itself.
An item likes a new forklift is a tangible asset. You can see and touch the forklift. Its value doesn’t lie in how it used or applied. It has intrinsic value on the fair market that is independent of how many crates it lifts per hour or how many days per year it is used.
If you are uncertain about whether to use amortization or depreciation, here’s a simple test. Amortization is used exclusively with the straight-line method of calculating amortization amounts. Depreciation may be used with either the straight line or accelerated method of depreciation.
The depreciation value of the forklift, for example, may be calculated through straight-line depreciation or in an accelerated method.
Straight-line depreciation: If the forklift was purchased for $25,000, and it has an estimated life of heavy use for five years, the depreciation amount is $5,000 per year.
Accelerated depreciation: Let’s assume that the forklift still costs $25,000, but the value decreases with heavy use. Assets may lose value at a different rate of speed; cars, trucks, forklifts are all good examples of losing value at varying speeds. In this example, the company believes the forklift will lose 50% of its value in year one, so it will only be worth $12,500 in years two through five. They might apply the following:
Years of useful life left / (4 + 3 + 2 + 1) x (original cost – salvage value)
5 / (10) x $25,000 – $12,500
.5 x $12,500 = $3,125
The company then applies $12,500 to tear one and $3,125 to subsequent years. This may be advantageous to the company. The company’s accountant must decide whether or not to take a straight-line depreciation or accelerated depreciation.
However, with a patent or other intangible asset, the value of the asset remains the same over time regardless of use. Straight-line depreciation always applies.
The Bottom Line
Amortization is an accounting term that refers to calculating and applying the value of an intangible asset over time. It differs from depreciation in that it always applies to intangible assets, while depreciation applies to tangible assets.