CFA Learnings: Amortization

We have been looking at the different accounting concepts learnt in the Corporate Financial Accounting (CFA) course, I wrote about Depreciation in the last CFA post and today I will be blogging about another concept called Amortization.

What is Amortization?

Amortization is the spread of the cost of an intangible asset over its useful life. Remember, we said assets are items that a company owns and controls that can bring in revenue. There are two main types of assets namely current assets and non-current assets. Current assets are assets that can be converted to cash within 12 months while non-current assets are assets that can be converted to cash after 12 months or assets that have a life span of more than a year. Current assets can be easily liquidated and used to fund the immediate or current needs of a business while Non-current assets are required for the long-term needs of a business. Under non-current assets, we have tangible and intangible assets. Check out my last post for the definition of tangible assets, now let us look at intangible assets.

Intangible assets are assets that are not physical and cannot be liquidated (converted into cash) easily. Companies and businesses would hold these assets on their balance sheet for more than a year. They include patents, software, trademarks and copyrights. For companies to be able to show the use of these assets and to show an accurate financial record, the costs of long-term assets are expensed each year of their useful life. This is where Amortization and Depreciation come in, they are the two main ways of calculating the value of long-term assets.

An example of Amortization can be seen in the use of a license fee for a truck for a company, this license fee will last for 5 years (its useful life). If the license fee costs us N50,000 and we amortize it evenly over the next 5 years, we would record N10,000 for each year as an expense in our income statement but the cost of the asset will reduce by N10,000 (from N50,0000 to N40,0000, to N30,000… till 0) in the balance sheet. This method is known as Straight-Line Amortization. Some of the other types of Amortization are:

• Declining Balance Amortization
•  Fixed Installment Amortization
•  Negative Amortization
•  Bullet Amortization
•  Fixed Installment Amortization
•  Units of production Amortization

Mathematically, Depreciation and Amortization are similar, the key difference is that Depreciation has to do with the spread of a long-term tangible asset like a machine or building over its useful life while Amortization has to do with the spread of the cost of an intangible asset over its useful life. I have mentioned before that the goal of the CFA class is not to make one an accountant overnight but to be familiar and knowledgeable with these terms so they can be applied in business and the work environment. I hope you found this discussion enlightening and useful. In the next episode of CFA Learnings, we will discuss another important accounting concept learnt in the course.