When an intangible asset is purchased, the item is added to the balance sheet as an account. Over the useful life, the value of the intangible asset is reduced through the process of amortization.
The amount of amortization in a given period is recorded as amortization expense (a non-cash activity) on the profit and loss statement.
These non-cash expenditures influence a company’s profitability and taxes due.
It’s important to have the correct book value for loans and intangible assets, like trademarks, copyrights, patents, and goodwill. That makes calculating amortization important for accounting and finance managers.
In order to start the amortization process, you will need:
Here is the straight line amortization formula:
Amortization Expense = (Book Value - Residual Value) / Useful Life
There are other amortization methods that may be used in particular situations.
This is an example of amortization for an intangible asset.
Intangible assets will lose value over time, so they should be amortized.
For example, Company A purchased a patent portfolio for $1,000,000. The portfolio has a residual value of $100,000 and a useful life of 5 years. Let’s look at the amortization expense, carrying value, and accumulated amortization using a straight line method.
Company A Patent Portfolio
Here is how we calculate the amortization expense:
Amortization = (Book Value - Residual Value) / Useful Life
Amortization = ($1,000,000 - $100,000) / 5 years
Amortization = $900,000 / 5 years
Amortization = $180,000 per year
The amortization of assets is important to make sure that the utility of the asset and their book balance on the balance sheet match. For instance, a company might undergo a rebranding and their old trademarks might have significantly less utility and value going forward.
The process is similar for loan repayment. This is an example of amortization for a loan.
Company A borrows $500,000 from a lender. The loan term is 6 years and the annual interest rate is 6.0%. Payments are made on a monthly basis. Let’s break down how the loan will be repaid.
Company A Loan
The loan payment formula is:
Payment = r(PV) / 1 - (1 + r)^-n
Where PV = present value, r = rate per period, and n = number of periods.
Since we are given an annual interest rate and monthly payments, we need to convert everything to monthly values. A 6% annual interest rate becomes 0.5% monthly interest rate. Similarly, 6 years needs to be translated into 72 months.
Present value simply refers to the loan value at the start of the period.
Here is the math:
Payment = 0.005(500,000) / 1 - (1 + 0.005)^-72
Payment = 2,500 / 1 - (1.005)^-72
Payment = 2,500 / 1 - 0.6983
Payment = 2,500 / 0.3017
Payment = $8,286
If Company A made 72 monthly payments of $8,286, they would pay back $596,592. $500,000 is principal and $96,592 is interest.
Note that there might be small changes in monthly payments and total payoff due to where you round the intermediary steps.
In most cases, the outstanding balance of the loan is repaid over several years. Periodic payments from the borrower to the lender are made – in most cases, these payments are made monthly.
The final loan payment will pay off the debt in full.
Here are the columns that you would expect to see:
The amortization process for an intangible asset can be more tricky. First, intangible assets could have a finite life or an infinite life.
If the asset has an infinite life, it is not amortized every year. Instead, it is tested in regular intervals for impairment. Impairment checks that the current book value reflects its actual economic value.
If the asset has a finite life, it could be amortized based on its contribution to revenue or in a straight line method. We used straight line amortization in our example above.
The profit and loss statement records all revenues and expenses in a given accounting period in order to arrive at a net income or net loss amount. That said, not all of the transactions impact cash.
For example, the value of a piece of machinery will decrease with its use. Equipment that costs $1,000,000 will slowly degrade over time. This degradation is shown as depreciation expense, which is reported on the income statement and lowers a company profit.
In order to work around these non-cash activities, analysts have started to look at earnings before interest, taxes, depreciation, and amortization (EBITDA) as a key profitability metric.
Amortization has a direct impact on multiple financial statements and impacts a company’s taxes due. Similar to depreciation, the Internal Revenue Service (IRS) has guidelines on how to amortize items for accounting and tax purposes.
Companies often use spreadsheets or financial software to keep track of their amortization. In addition, an amortization schedule is a useful tool to keep track of your different assets, loans, interest rates, and formulas.
Many lenders and analysts will look at EBITDA (which excludes non-cash expenditures) to get a more accurate view of the underlying business operations.
Track metrics like the top performing ecommerce stores.