Amortization is the periodic expensing of an intangible asset over the asset’s estimated useful life. Common intangible assets include copyrights, trademarks, and patents.
Like depreciation, amortization is accumulated into an account which offsets the carrying value of the intangible asset. However, unlike tangible assets, intangible assets generally do not have residual value. Thus, amortized intangible assets are fully written-off over the asset’s estimated useful life.
Amortization is also similar to depreciation in that it is a non-cash expense. Thus, amortization is added-back to income when calculating operating cash flow.
An important intangible asset is acquired goodwill. Goodwill arises when a company purchases another at a price which exceeds the value of the identifiable assets (both tangible and intangible). The treatment of goodwill differs for tax and financial reporting purposes. If the acquisition is structured as an asset purchase, goodwill can be amortized for tax purposes in accordance with applicable tax rules. Under GAAP accounting, however, goodwill is not amortized. Rather, goodwill is tested annually for impairment and is written down if the company’s management identifies such an impairment.
The concept of amortization presented here should not be confused with the concept of loan amortization, which refers to the periodic reduction in a loan’s principal.
