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Amortization

Amortization is often regarded as being the same as depreciation, but although the two accounting practices can be difficult to distinguish, there are differences between them. Amortization is also used in connection with loans, although that is not the primary focus here.

What It Measures
Amortization is a method of recovering (deducting or writing off) the capital costs of intangible assets over a fixed period of time. Its calculation is virtually identical to the straight-line method of depreciation. Amortization also refers to the establishment of a schedule for repaying the principal and interest on a loan in equal amounts over a period of time. Because computers have made this a simple calculation, business references to amortization tend to focus more on the terms first definition.

Why It Is Important
Amortization enables a company to identify its true costs, and thus its net income, more precisely. In the course of their business, most enterprises acquire intangible assets such as a patent for an invention, or a well-known brand or trademark. Since these assets can contribute to the revenue growth of the business, they can beand are allowed to bededucted against those future revenues over a period of years, provided the procedure conforms to accepted accounting practices. For tax purposes, the distinction is not always made between amortization and depreciation, yet amortization remains a viable financial accounting concept in its own right.

How It Works in Practice


Amortization is computed using the straight-line method of depreciation: divide the initial cost of the intangible asset by the estimated useful life of that asset. For example, if it costs $10,000 to acquire a patent and it has an estimated useful life of 10 years, the amortized amount per year is $1,000. 10,000 10 = $1,000 per year The amount of amortization accumulated since the asset was acquired appears on the organizations balance sheet as a deduction under the amortized asset. While that formula is straightforward, amortization can also incorporate a variety of noncash charges to net earnings and/or asset values, such as depletion, write-offs, prepaid expenses, and deferred charges. Accordingly, there are many rules to regulate how these charges appear on financial statements. The rules are different in each country, and are occasionally changed, so it is necessary to stay abreast of them and rely on expert advice. For financial reporting purposes, an intangible asset is amortized over a period of years. The amortizable life useful lifeof an intangible asset is the period over which it gives economic benefit. Several factors are considered when determining this useful life; for example, demand and competition, effects of obsolescence, legal or contractual limitations, renewal provisions, and service life expectations. Intangibles that can be amortized include: Copyrights, based on the amount paid either to purchase them or to develop them internally, plus the costs incurred in producing the work (wages or materials, for example). At present, a copyright is granted for the life of the author plus 70 years. However, the estimated useful life of a copyright is usually far shorter than its legal life, and it is generally amortized over a fairly short period. Cost of a franchise, including any fees paid to the franchiser, as well legal costs or expenses incurred in the acquisition. A franchise granted for a limited period should be amortized over its life. If the franchise has an indefinite life, it should be amortized over a reasonable period, not to exceed 40 years.
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Amortization

Covenants not to compete: an agreement by the seller of a business not to engage in a competing business in a certain area for a specific period of time. The cost of the not-to-compete covenant should be amortized over the period covered by the covenant unless its estimated economic life is expected to be shorter. Easement costs that grant a right of way may be amortized if there is a limited and specified life. Organization costs incurred when forming a corporation or a partnership, including legal fees, accounting services, incorporation fees, and other related services. Organization costs are usually amortized over 60 months. Patents, both those developed internally and those purchased. If developed internally, a patents amortizable basis includes legal fees incurred during the application process. Normally, a patent is amortized over its legal life, or over its remaining life if purchased. However, it should be amortized over its legal life or its economic life, whichever is the shorter. Trademarks, brands, and trade names, which should be written off over a period not to exceed 40 years. However, since the value of these assets depends on the changing tastes of consumers, they are frequently amortized over a shorter period. Other types of property that may be amortized include certain intangible drilling costs, circulation costs, mine development costs, pollution control facilities, and reforestation expenditures. They can even include intangibles such as the value of a market share or a markets composition: an example is the portion of an acquired business that is attributable to the existence of a given customer base.

Tricks of the Trade


Certain intangibles cannot be amortized, but may be depreciated using a straight-line approach if they have a determinable useful life. Because the rules are different in each country and are subject to change, it is essential to rely on specialist advice. Computer software may be amortized under certain conditions, depending on its purpose. Software that is amortized is generally given a 60-month life, but it may be amortized over a shorter period if it can clearly be established that it will be obsolete or no longer used within a shorter time. Under certain conditions, customer lists that were purchased may be amortized if it can be demonstrated that the list has a finite useful life, in that customers on the list are likely to be lost over a period of time. While leasehold improvements are depreciated for income tax purposes, they are amortized when it comes to financial reportingeither over the remaining term of the lease or their expected useful life, whichever is the shorter. Annual payments incurred under a franchise agreement should be expensed when incurred. The internet has many amortization loan calculators that can automatically determine monthly payment figures and the total cost of a loan.

More Info
Websites:
Financial Accounting Standards Board: www.fasb.org US Copyright Office: www.copyright.gov US Patent and Trademark Office: www.uspto.gov

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Amortization

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