Amortization

What It Is:

Amortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a period of time. It also refers to the repayment of loan principal over time.

How It Works/Example:

Let's assume Company XYZ owns the patent on a piece of technology, and that patent lasts 15 years. If the company spent $15 million to develop the technology, then it would record $1 million each year for 15 years as amortization expense on its income statement.

Alternatively, let's assume Company XYZ has a $10 million loan outstanding. If Company XYZ repays $500,000 of that principal every year, we would say that $500,000 of the loan has amortized each year.

Why It Matters:

The length of time over which various intangible assets are amortized vary widely, from a few years to as many as 40 years.  As a general rule, an asset should be amortized over its estimated useful life, or the maturity or loan period in the case of a bond or a loan.  If an intangible asset has an indefinite life, such as goodwill, it cannot be amortized.

It is important to note that the term amortization refers to intangible assets; the term depreciation refers to tangible assets, and the term depletion refers to natural resources.