Amortization plays an important part in business lending as well as home mortgages. It is also an essential part of the business accounting process. Corporations and investors alike measure their wealth by a balance sheet that calculates the ebb and flow of money throughout the term of a loan. These earnings and expenses are added to the other business revenue and expenses to determine if the fiscal year was profitable.
Business owners and investors try to plan as much profit as possible to offset the costs and potential downturns in a year. There are two accounting principles that help to limit the negative impact of expenses and take advantage of profits: depreciation and amortization.
Depreciation and amortization are a part of what is called “accrual” accounting. Unlike cash accounting, which only deals with earnings and expenses at the moment when cash is exchanged, accrual accounting allows companies to spread out the cost of a business expense over the life of the investment. Examples of investments include company equipment, intellectual property, internet domain names and brand costs.
Depreciation refers to the loss of value over time. It is a term used with physical assets, such as factory equipment, computers or delivery trucks. For intangible assets such as licenses, franchises, copyrights and so on, amortization is used to calculate the value of payments made over time.
As an example, if Company A creates a new online business and purchases the domain name for 5 amount of years, they can amortize, or spread out, the cost of that domain name for the 5 years. Instead of one large expense on their balance sheet, Company A now has several smaller transactions, which boosts the fiscal year’s profit.
Another term related to amortization is “goodwill.” Goodwill is an accounting term for paying above fair market value for a property or service. For example, if a real estate property is worth $300,000 but the buyer purchases it for $350,000 due to the seller’s excellent reputation and service, the extra $50,000 is termed goodwill and may be added as an intangible expense to be amortized on the buyer’s balance sheet.
These are some of the benefits of the process of amortization.