Amortization is an accounting method for spreading out the costs for the use of a long-term asset (such as intellectual property) over the lifetime of this long-term asset.

Amortization expenses account for the cost of long-term assets (like computers and vehicles) over the lifetime of their use. Also called depreciation expenses, they appear on a company’s income statement.

When an amortization expense is recorded on the Income Statement, the value of the long-term asset recorded on the balance sheet is reduced by the same amount. This continues until the cost of the asset is fully expensed or the asset is sold or replaced. Tax authorities always set annual limits on how much of a long-term asset’s cost can be amortized in a given year. These limits are called capital cost allowances.

The term depletion expense is similar to amortization but it refers only to natural resources like timber.

Types of Amortization

There are two types of amortization:

Straight-Line Amortization Method

Let’s use an example to illustrate this method. Let’s assume that a business purchases some equipment for $100,000 and this piece of equipment is expected to have a life span of 5 years.

The purchase price of the equipment is divided by 5 and thus $20,000 is allocated in the income statement as an expense each year.

So the company deducts $20,000 from its taxable income every year over 5 years. This enables the business to reduce its tax bill.

Declining Balance Amortization Method

Some assets such as vehicles lose much of their value early on as soon as they are taken off the car lot. This significant drop in value early on is accounted for in the declining balance amortization method.

Amortization is a Non-Cash Expense

Amortization is an unusual type of expense because there is no cash outflow from the business every year even though it is recorded in the Income Statement as an expense.

This amortization expense reduces taxable earnings of the business. Because this non-cash expense can distort the performance metrics of the business, they are often excluded when analyzing a company’s annual business performance.

Hence the popular use of the metric Earnings before Interest, Taxes, Depreciation and Amortization or EBITDA.

Capital Cost Allowance

Tax authorities require businesses to amortize the costs of long-term assets over the lifetime of their use to claim a Capital Cost Allowance.

This offers businesses the opportunity too to accelerate or defer some amortization to optimize their tax bills.

Amortization of Intangible Assets

Intangible assets such as a trademarks or patents, exist as long as the business is active. These assets cannot be depreciated on the balance sheet, but their value may be re-assessed.

However, the cost of these assets can be amortized for tax purposes over time.

Difference Between Amortization and Depreciation

Amortization is used to spread out the cost of tangible and intangible and tangible business assets.

Depreciation is used to calculate how wear and tear and obsolescence reduce the value of tangible assets.