What is Amoritization? How to Spread Costs Over Time

Spreading costs over time with amortization.

In the world of finance, accurately reflecting the value of assets over their lifespan is crucial. Amortization plays a vital role in achieving this objective. It’s a systematic process of spreading the initial cost of an intangible asset, or a tangible asset with a limited lifespan, over its estimated useful life. This article delves into the world of amortization, exploring its purpose, applications, benefits, best practices, and how Airbase, a financial management platform, streamlines the process.

What is amortization?

Imagine your company purchases a new software license for $10,000. The entire cost shouldn’t be considered an expense solely in the year of purchase. The software will likely be used (and depreciate in value) over several years. Simply recording the entire cost as an expense in the first year would distort your company’s financial picture and profitability.

Amortization addresses this issue by providing a systematic way to allocate the cost of the asset over its useful life. This approach allows for a more accurate representation of a company’s financial health and expenses in each accounting period.

Types of amortization.

There are two primary types of amortization used in accounting:

• Intangible asset amortization: This applies to assets that lack a physical form but have a definite useful life, such as patents, copyrights, trademarks, and goodwill. The cost of intangible assets is spread over their estimated useful life using an amortization schedule.
• Tangible asset depreciation: This applies to tangible assets with a limited lifespan, such as machinery, buildings, and vehicles. The cost of these assets is spread over their estimated useful life through depreciation. While conceptually similar to amortization, depreciation is used specifically for tangible assets. This article focuses on amortization specifically for intangible assets.

How to calculate amortization expense.

Calculating amortization is a straightforward process that relies on the following information:

• Cost of the intangible asset: This is the initial purchase price of the asset.
• Estimated useful life: This is the number of years the asset is expected to be used or remain valuable to the company. Often, this is determined by legal regulations or industry standards.
• Salvage Value: This is the estimated value of the asset at the end of its useful life. Some intangible assets may have no salvage value (e.g., a patent expires after a set period and has no remaining value).

The most common formula for calculating annual amortization expense is:

Annual Amortization Expense = (Cost of Asset – Salvage Value) / Estimated Useful Life

Benefits of amortization.

Implementing amortization offers several benefits for businesses:

• Accurate financial reporting: By spreading the cost over its useful life, amortization reflects the gradual decrease in the asset’s value. This ensures your financial statements present a more accurate picture of your company’s financial position and profitability.
• Matching principle: The matching principle in accounting requires expenses to be matched with the revenues they help generate. Amortization aligns with this principle by allocating a portion of the asset’s cost to each period it is used to generate revenue.
• Tax implications: In many tax jurisdictions, the Internal Revenue Service (IRS) allows businesses to deduct a portion of the asset’s cost from their taxable income each year through amortization. This can lead to significant tax savings.

What is an amortization schedule and what are the best practices?

An amortization is a table or chart that outlines both loan and payment information for reducing loan terms. Maintaining an effective amortization schedule communicates information to the borrower and lender.

• Accurate initial information: Ensure the initial cost of the asset, estimated useful life, and salvage value are accurately determined based on reliable sources and industry standards.
• Documentation and tracking: Document all relevant details about the intangible asset, including its purchase date, cost, estimated useful life, and amortization schedule. Maintain a centralized system to track amortization calculations and ensure timely recording of amortization expenses.
• Regular review and adjustments: Periodically review the estimated useful life of the asset, especially if circumstances change (e.g., technological advancements in software). If necessary, adjust the amortization schedule accordingly.
• Internal controls: Implement internal controls to ensure proper authorization for intangible asset purchases and accurate amortization calculations.

How Airbase helps with amortization.

Managing intangible assets and their associated amortization schedules can be time-consuming and prone to errors, especially for companies with numerous intangible assets. This is where Airbase, a comprehensive financial management platform, steps in.

• Automated amortization schedules: Airbase eliminates the manual creation and maintenance of amortization schedules. You simply enter the initial cost, estimated useful life, and Airbase automatically generates a detailed amortization schedule.
• Seamless integration with accounts payable (AP): Airbase integrates seamlessly with your existing accounts payable system. When a pre-paid expense for an intangible asset is recorded, Airbase automatically schedules the amortization expense for each period throughout the useful life. This eliminates the need for manual entries in your accounting software.
• Flexible schedule options: Airbase allows you to use either a straight-line amortization method (the most common), or for NetSuite or Sage Intacct, users choose from pre-defined amortization templates offered by those ERPs for more complex amortization scenarios.
• Real-time visibility: Airbase provides real-time access to your amortization schedules, allowing you to easily track the remaining book value of your intangible assets and monitor their depreciation over time.
• Improved accuracy and efficiency: By automating amortization calculations and integration with AP, Airbase minimizes the risk of errors associated with manual data entry. This saves valuable time and resources for your accounting team.
• Reduced risk of audit issues: A well-maintained and accurate amortization schedule is crucial during audits. Airbase helps ensure your amortization calculations are documented and readily accessible for auditors.
• Beyond amortization: Airbase as a comprehensive solution.

While amortization is a key feature, Airbase offers a holistic range of financial management functionalities that integrate seamlessly.

• Spend Management: Gain insights into your spending data to identify cost-saving opportunities and optimize your procurement processes.
• Bill Pay: Streamline your invoice processing and payment workflows with automated features.
• Virtual Cards: Issue virtual cards for specific purchases, improving expense control, and real-time visibility.
• Real-Time Reporting: Access comprehensive financial reports and data insights to make informed business decisions with real-time reporting.