Explaining Amortization in the Balance Sheet

Reviewed by David KindnessFact checked by Vikki Velasquez

Over a decade ago, the U.S. Bureau of Economic Analysis announced a change to the way it estimates gross domestic product (GDP). Going forward, it was going to include intangible assets in its calculations of investments in the economy.

The change significantly boosted economic growth and made the economy nearly $560 billion larger than previously estimated. Now that intangible assets are considered long-lived assets in the economy, accountants will have to amortize their amount over time when preparing financial statements.

Amortization is an important concept not just to economists, but to any company figuring out its balance sheet.

Amortization

Amortization refers to capitalizing the value of an intangible asset over time. It’s similar to depreciation, but that term is meant more for tangible assets.

Amortization occurs when the value of an asset, usually an intangible asset, like research and development (R&D) or a trademark, is reduced over a specific time period, which is usually the asset’s estimated useful life.

A good way to think of this is to consider amortization to be the cost of an asset as it is consumed or used up while generating sales for a company. Along with the useful life, major inputs into the amortization process include residual value and the allocation method, the last of which can be on a straight-line basis.

A more specialized case of amortization takes place when a bond that is purchased at a premium is amortized down to its par value as the bond reaches maturity. When a bond is purchased at a discount, the term is called accretion. The concept is again referring to adjusting value overtime on a company’s balance sheet, with the amortization amount reflected in the income statement.

A rule of thumb on this is to amortize an asset over time if the benefits from it will be realized over a period of several years or longer. With a short expected duration, such as days or months, it is probably best and most efficient to expense the cost through the income statement and not count the item as an asset at all.

Examples of Intangible Assets

Other examples of intangible assets include customer lists and relationships, licensing agreements, service contracts, computer software, and trade secrets (such as the recipe for Coca-Cola). Goodwill is another major intangible asset. It used to be amortized over time but now must be reviewed annually for any potential adjustments.

A good example of how amortization can impact a company’s financials in a big way is the purchase of Time Warner in 2000 by AOL during the dot-com bubble. AOL paid $162 billion for Time Warner, but AOL’s value plummeted in subsequent years, and the company took a goodwill impairment charge of $99 billion. In previous years, this amount would have been amortized over time, but it must now be evaluated annually and written down if, as in the case of AOL, the value is no longer there.

GAAP vs. IFRS

Firms must account for amortization as stipulated in major accounting standards. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) both have similar definitions of what qualifies as an intangible asset, but there are differences in how their values must be adjusted over time.

For instance, development costs to create new products are expensed under GAAP (in most cases) but capitalized (amortized) under IFRS. GAAP does not allow for revaluing the value of an intangible, but IFRS does. This means that GAAP changes in value can be accounted for through changing amortization schedules, or potentially writing down the value of an intangible, which would be considered permanent. Finally, GAAP stipulates that advertising expenditures be expenses as incurred, but IFRS does allow recognizing a prepayment of these expenses as an asset, which would be capitalized or amortized as they are used at a later date.

The Bottom Line

Amortization reflects the fact that intangible assets have a value that must be monitored and adjusted over time. The amortization concept is subject to classifications and estimates that need to be studied closely by a firm’s accountants, and by auditors that must sign off on the financial statements.

Read the original article on Investopedia.