How Amortization Works

Amortization and Business Accounting

Accrual accounting -- another form of amortization -- allows companies to spread the cost of certain expenses over several years.
Accrual accounting -- another form of amortization -- allows companies to spread the cost of certain expenses over several years.
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A business measures its success by its balance sheet. More importantly, so do investors. The balance sheet lists all of the earnings and expenses that determine if the fiscal year ends in a profit or a loss. To please shareholders and prospective investors, business owners try to keep as much in the positive column as possible and limit the negative impact of expenses. One way to do that is through two important accounting principles: depreciation and amortization.

Depreciation and amortization are both principles of accrual accounting. Accrual accounting is different than cash accounting, which only recognizes earnings and expenses at the moment when cash changes hands. Instead, accrual accounting allows a company to spread out the cost of a business expense -- equipment, machinery, intellectual property, even brand names and Internet domain names -- over the life of the investment [source: FinancialWeb].

Depreciation is used for the purchase of tangible items, like a delivery truck, factory equipment or a laptop computer used for business purposes. Amortization, however, is primarily used for so-called "intangible assets."

Let's look at the example of patents, one of these intangible assets. It costs money to apply for and receive a patent, including the cost of a patent attorney. The legal life of a patent is 17 years [source: Cliffs Notes]. According to Generally Accepted Accounting Principles (GAAP) and section 197 of the U.S. Tax Code, a company can amortize, or spread out the cost of, the patent over those 17 years. So instead of registering one big expense on this year's balance sheet, it can register 17 much smaller expenses on the next 17 balance sheets. The result is that this year's profit will look bigger.

Other common intangible assets are copyrights, trademarks, franchises, brand names, licenses, permits, market share, "non-compete" agreements and something called "goodwill." Goodwill is the accounting term for paying above the fair market value for a good or service. If a company is worth $1 million in assets, but you buy it for $1.2 million because the company has a great reputation, that extra $200,000 is called goodwill and it's an intangible expense that you can amortize on your balance sheet.

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