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Accounting, as has often been said, is the “language of business.” For a small business owner, accounting can be confusing and demanding because many concepts, formulas, and documents must be understood to achieve success. Two of those concepts are amortization and depreciation. Amortization in accounting can refer to both amortization of assets and amortization of loans.  

What is Amortization in Accounting?

Amortization in accounting refers to the process of spreading the cost of intangible assets over their useful life, thus spreading expenses over multiple years. The process of amortization is intended to spread costs accurately and systematically over an asset’s life so that a company’s financial records provide a clear and accurate picture of its financial performance. 

An asset’s “useful life” is either the period in which it is useful to the owner or its contractual/legal life, such as when a patent or license expires. 

Assets that can be amortized include patents, copyrights, trademarks, customer lists, software development costs, and licenses. 

In its loan financing application, amortization front loads interest payments, so borrowers pay more deductible interest up front, with increasing amounts of principal paid as a loan matures. 

What is Depreciation? 

Depreciation refers to the process of expensing the cost of a fixed (instead of intangible) asset over its useful life. Fixed assets include buildings, vehicles, machinery, equipment, and office furniture. The depreciated amount can be expensed each year as a tax deduction until the useful life of the specific asset has expired.

The Benefits of Amortization in Accounting  

The benefits of amortization in accounting include: 

  • Financial recording. Distributing an asset’s cost systematically over its useful life matches expenses with the revenue or benefits of an asset more precisely, thus providing a more accurate picture of a company’s financial condition. 
  • Beneficial allocation of expenses. Spreading asset costs decreases the negative impact of upfront expenses, thus smoothing expenses over an asset’s lifespan. 
  • Better asset valuation. Displaying the gradual reduction in the value of an intangible asset helps with decision-making and enables better estimating of the actual value of company assets. 
  • Deducting taxes. Amortizing in accounting offers businesses tax benefits by reducing their tax liabilities. 
  • Financial planning. Amortizing enables better budgeting and financial planning through a better understanding of the costs of long-term assets and liabilities. It helps a business forecast and allocate future expenses, thus benefiting better cash flow management and enabling better long-term financial stability.

How to Calculate Amortization 

Calculating amortization requires establishing the initial value of each asset, its useful life remaining, and the asset’s residual value. The mathematical approach is two-fold:

  1. Subtract the residual value from the amount that the asset was acquired.
  2. Divide that figure by the number of months remaining in the asset’s useful life. That results in the periodic amount that can be amortized. Amortization is generally done using the “straight-line method,” resulting in the same amount being recorded yearly.

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