Amortization is the decrease in value of an intangible asset or assets over time
Amortization is an accounting term used to rectify the cost of intangible assets with the decrease in value over their useful life. Typically, amortization is used to devalue intellectual property, patents, or copyrights whose value has a limited life-span. It is reported as an expense on the income statement (usually as "amortization" though often lumped together with depreciation or sometimes in an overarching category like "other"). However, since it is a non-cash expense, amortization is never actually paid for (no cash changes hands) and, as such, is added back to the total cash from operating activities on the cash flow statement. Thus, amortization actually increases a company's free cash flow while decreasing earnings.
While in theory amortization is used to account for the decreasing value of acquired or developed intangible assets (for example, a new, patented, process for refining crude oil) in practice amortization is often used to spread the payment of one-time expenses over several years, generating a higher net income by reducing expenses on the income statement. By contrast, a highly profitable company looking to decrease their tax payments may list what should typically be an amortized expenditure as a one-time expense on the income statement, reducing their net income for the year and thus decreasing the amount of money owed for taxes.
Amortization is similar to depreciation in that the value of the asset or liability is reduced over time. The key difference is that depreciation refers to tangible assets, like machinery or buildings, while amortization refers to intangible assets such as patents.
Amortization is also a key component of EBITDA, or "Earnings Before Interest, Tax, Depreciation, and Amortization".
Examples
- Company XYZ, a mining company, develops and patents a new chemical process used in the the extraction of sulfur. The development of this process costs the company $10,000 and is expected to remain a valuable and exclusive practice over the coming 10 years. Since this cost can be thought of as an investment in the company, XYZ lists the $10,000 under cash flows from investing activities. Using straight-line amortization, the company lists amortization costs of $1000 a year for the next ten years as a non-cash expense on both the income statement and cash flow statement.
- Company ABC, a highly profitable oil company, spends $1,000,000 developing a more efficient process to refine crude oil. While the company could list this expense as a negative cash flow from investing activities and amortize the process' value over a period of several years, they instead list the payment as an R&D expense, thereby decreasing net income and diminishing ABC's tax burden for the fiscal year.
- Company LMN, an upstart renewable energy company, spends $100,000 surveying a site for a potential wind farm. Under most circumstances, LMN would list this as a one time R&D expenditure; however, in an effort to demonstrate a healthier net income to shareholders, LMN instead decides to list this figure under cash flows from investing activities, then amortizes it over a period of 10 years (thereby bolstering the company's net income).
