When researching accounting processes, you may encounter amortization. It’s commonly used to distribute the cost of business-related assets over time. Amortization, however, isn’t the same as depreciation. If you’re thinking about using it, there are several things you need to know about amortization and how it works.
What Is Amortization?
Amortization refers to the process of gradually expensing the cost of an intangible asset over its useful life. This is similar to depreciation, which refers to the gradual expensing of the cost of tangible assets.
Depreciation revolves around tangible assets. Amortization, on the other hand, revolves around intangible assets. To expense the cost of a tangible asset, you should use depreciation. For intangible assets, you should use amortization.
How Does Amortization Work?
Intangible assets include patents, trademarks, copyrights and goodwill, which are often long-term assets that provide value to a business over a period of years. Rather than recording the full cost of these assets as an expense in the year in which they are purchased, businesses record a small portion of the cost each year as an amortization expense.
The amortization expense is calculated by dividing the total cost of the asset by its estimated useful life. For example, if a business spends $100,000 on a patent that has an estimated useful life of 10 years, the business would record an annual amortization expense of $10,000 per year for a period of 10 years.
Benefits of Amortization
Amortization helps to ensure that the total cost of intangible assets is spread over their useful lives. This allows for more accurate financial reporting that reflects the true cost of the respective assets over time.
Another benefit of amortization is better budgeting. By spreading the cost of an intangible asset over its useful life, businesses can better plan for expenses and budget accordingly. Businesses can make smarter decisions regarding how to spend their capital and allocate their resources.
There are even tax benefits associated with amortization. Amortization expenses can typically be deducted from taxable income, which in turn reduces the tax liability of businesses.
If you use the Generally Accepted Accounting Principles (GAAP) standard for your business’s accounting needs, you’ll need to use amortization. Amortization is an element of the GAAP. To comply with the GAAP, you’ll need to expense the cost of intangible assets over their useful lives.
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