What it means
When a company buys a patent for $1 million that will protect a product for ten years, it has not lost $1 million on the day of purchase; it has acquired ten years of protection. Charging the whole cost in year one would understate that year's profit and overstate the next nine.
Amortization spreads the cost so each year bears a share. The usual method is straight-line, giving an equal charge each year, and unlike physical assets, intangibles are normally assumed to have no residual value at the end.
Some intangibles, such as goodwill under IFRS and certain brands, are judged to have indefinite lives and are not amortized but are instead tested for impairment each year. On the balance sheet, accumulated amortization reduces the intangible asset's carrying value over time.
In the cash flow statement, amortization is added back to profit because it is a non-cash charge, which is why EBITDA (earnings before interest, taxes, depreciation and amortization) excludes it. Companies that grow by acquisition often carry large amortization charges on acquired intangibles, and analysts frequently look at profit before those charges to judge underlying performance.
In lending, an amortizing loan is one where each payment is calculated so that the loan is fully repaid at the end of the term. Early payments are mostly interest, because the balance is high; later payments are mostly principal.
An amortization schedule lists every payment and its split, and shows the remaining balance after each. Mortgages, car loans and most term loans work this way.
The alternative is an interest-only loan, where the principal is repaid in one lump sum (a bullet or balloon payment) at the end.
In practice
Real-world examples.
Example
A pharmaceutical company amortizes a $50 million drug licence over the twelve years remaining on the patent, charging about $4.2 million a year.
Example
A homeowner with a 30-year mortgage notices that in the first year only about a fifth of each payment reduces the principal, and that making one extra payment a year shortens the loan by several years.
Example
An acquirer that paid $30 million for a competitor allocates $8 million of the price to customer relationships and amortizes them over eight years, reducing reported profit by $1 million a year with no effect on cash.
Think of it
“Amortization is like slicing a cake into equal pieces to share over time-whether it's the value of an asset or the repayment of a loan.
Formula
Calculation
Intangible asset: Annual Amortization = (Cost minus Residual Value) / Useful Life
Loan: Payment = P x [ r (1 + r) to the power n ] / [ (1 + r) to the power n minus 1 ], where P is the principal, r the interest rate per period and n the number of payments
Worked example 1, an intangible. A software company buys a licence for $240,000 with a six-year life and no residual value.
- Annual amortization = $240,000 / 6 = $40,000
- After three years: accumulated amortization $120,000, carrying value $120,000
Worked example 2, a loan. A business borrows $100,000 over five years at 6% a year with monthly payments.
- Monthly rate r = 0.06 / 12 = 0.005; number of payments n = 60
- Payment = $100,000 x [ 0.005 x 1.34885 ] / [ 1.34885 minus 1 ] = $1,933.28 per month
- Month 1: interest = $100,000 x 0.005 = $500.00; principal = $1,433.28; balance = $98,566.72
- Month 2: interest = $492.83; principal = $1,440.45; balance = $97,126.27
- Month 60: interest = $9.62; principal = $1,923.66; balance = $0
Total paid over the term = 60 x $1,933.28 = $115,997, of which $15,997 is interest.Case study
Seen in the real world.
A media company acquired a rival for $45 million and, following the accounting rules, allocated $18 million of the price to acquired subscriber relationships and brand names with lives of five to ten years. The resulting amortization charge of $2.6 million a year pushed the enlarged group's reported profit below what the two businesses had made separately, and the share price fell as some investors concluded the deal had failed. The chief financial officer began reporting adjusted earnings excluding acquisition amortization alongside the statutory figures, with a clear reconciliation, and explained that the charge reflected the purchase price of assets already paid for, not an ongoing cash cost.
Cash flow, which had risen 20% because of the acquisition, made the same point. Over the following year the market's focus moved to cash generation and the shares recovered. The company kept both measures in its reports so that readers could see the accounting charge and the underlying trading side by side.
Watch out
Common mistakes.
- Confusing amortization with depreciation. They work the same way but apply to intangible and tangible assets respectively.
- Assuming a loan balance falls evenly. In the early years of an amortizing loan most of each payment is interest.
- Treating acquisition amortization as a sign of poor trading. It is a non-cash allocation of a price already paid; look at cash flow alongside it.
Questions
People also ask.
Is goodwill amortized?
Under IFRS and US GAAP for listed companies, no; it is tested annually for impairment. Some private company frameworks allow amortization over a set period.
What is negative amortization?
A loan where payments are less than the interest due, so the balance grows. It is rare and risky.
Does amortization affect cash?
No. It is an accounting charge. The cash left when the asset was bought or when loan payments are made.
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