What is amortization and why do we amortize?

Amortization is a simple way to evenly spread out costs over a period of time. Typically, we amortize items such as loans, rent/mortgages, annual subscriptions and intangible assets.

Let’s start with the loans and rent/mortgages… In many instances, payments made to repay loans or pay for rent vary according to the terms of the agreement. In order to spread the total cost according to the agreement evenly over the life of the terms, we amortize.

For example, Company ABC has a one year rental agreement where the first two months are free and the company pays $3,000/month the last ten months of the lease. If rent is recorded based on what is paid, the company would not have rent expense the first two months of the contract. For items such as rent that is a contracted amount, we want to spread it out evenly throughout the year. This allows us to clearly see where expenses are changing and can assist in analysis. To find out what we amortize each month, first we need to find out the total expense over the life of the contract:

$3,000 x 10 months = $30,000

So each month we will want to expense $2,500 for rent ($30,000/12 months). The difference between this expense and our actual cash payment is amortization. The journals are as follows:

Months 1-2

DR. Rent Expense $2,500

CR. Rent Amortization $2,500

Months 3-12

DR. Rent Expense $2,500

DR. Rent Amortization $500

CR. Cash $3,000

At the end of the rental agreement, the amortization should net out to zero and all expenses should be accounted for and spread out evenly throughout the year. An amortization schedule similar to the one below is useful for tracking payments, expenses, and amortization balances.

Date

Payment

Straight Line Expense

Rent Amortization

1/1/11

2,500

2,500

2/1/11

2,500

5,000

3/1/11

3,000

2,500

4,500

4/1/11

3,000

2,500

4,000

Similarly, we create schedules and amortize for loans and other contracted liabilities. Amortizing intangible assets, on the other hand, is a little different. Amortization of an intangible asset is the equivalent to depreciating a tangible asset like equipment. Intangibles are assets like patents and licenses that are of significant value to a company and have an estimated useful life. The cost is amortized over the useful life to record expenses in the period they are used.

Amortization is an important part of accounting. It allows us to expense items in the periods they are used, giving us a much clearer picture of how the business is performing. Contact a local accounting firm, like TGG Accounting, to identify what items you have in your business that should be amortized.

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 Written by:
Ashley Peth
TGG Accounting
 
 
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