What is Amortization Expense?

(Last Updated On: March 21, 2022)

In accounting, expenses are not always recognized in a single period, because it goes against the matching principle and distorts the financial performance of an organization. As a result, certain expenses are amortized over a specified amount of time, so expenses are recognized in the appropriate accounting periods. Understanding amortization is important for accountants and consumers alike.

Read on to get a better understanding of what the amortization expense is, how to record an entry and how to calculate the expense.

What Does Amortization Mean?

Amortization involves the systematic reduction of an account balance, such as prepaid expenses and capitalized loan costs, over a specified time. Simply stated, amortization is the process of reducing an amount such as a loan balance for a mortgage or auto loan by making monthly payments. In accounting, amortization tables or amortization calculators are used as support for journal entries and reconciliations that involve annual amortization expense. Amortization factors into financial planning. However, metrics such as EBITDA – earnings before interest, taxes, depreciation and amortization – exclude amortization to get a true sense of operational profitability.

Amortization Expense Example

The cost of an intangible asset or non-physical assets, are amortized over a set number of periods. Examples of intangible assets include prepaid insurance, patents, trademarks and copyrights. Since insurance policies are typically written for an annual period, a premium payment can be amortized over a 12-month period. The prepaid is amortized equally over the 12-month term, so that the company can recognize the insurance coverage expense in the correct periods. The prepaid expense entry is often automated as part of the general ledger system and month-end-close process. If additional insurance coverage were added and a new premium paid, it could change how the prepaid insurance line item on the balance sheet is accounted for.

Entering An Amortization Journal Entry

When entering an amortization expense journal entry, it is important to remember that the balance sheet and income statement are impacted. The prepaid expense account or the value of the intangible asset on the balance sheet is credited or reduced, and the expense account is entered as a debit or increased. The journal entry should have support, such as an amortization table and listing of prepaid expenses attached to it, as support for the entry. Unsupported prepaid assets on the company’s balance sheet pose a risk to accountants and decision-makers alike.

Calculating Amortization Expense

Amortization expense is typically calculated using a schedule that illustrates a beginning balance, and a series of equal expenses, that reduce the beginning balance to zero. The amortization table can be relatively simple and is oftentimes created in Excel. Dividing the beginning balance by the number of amortization periods typically yields the amortization amount. There are some general ledger accounting software that can automate the calculation of amortization expense. Automated reconciliation applications may also have an amortization table functionality. The expense amounts are ultimately used as a tax deduction which decreases the tax liability for the entity.

Depreciation Vs. Amortization

Tangible fixed assets, such as property, plant and equipment, are recorded at cost and are depreciated over a specified useful life. Accumulated depreciation, which is the sum of all depreciation expenses recorded over the life of an asset, is displayed on the balance sheet. This methodology is only used for tangible assets, though. Intangible assets, such as prepaid rent, can be amortized but not depreciated. This is an important distinction that accountants must observe every month-end-close.

Risks Associated With Amortizing Prepaids

Prepaid expenses can be manipulated to conceal theft or fraud. For example, cash can be taken from a bank account and a false prepaid asset can be created, to conceal the theft. As such, amortization schedules should be reconciled against other supporting documents to ensure accurate amortization expense recognition. Internal control over amortization expense is important for all stakeholders in a business.

Amortization is important because it helps businesses recognize expenses in the appropriate accounting period. This has a myriad of benefits, including relevant financial reports that help investors, owners and other stakeholders make effective economic decisions.

Read on to get a better understanding of what the amortization expense is, how to record an entry and how to calculate the expense.

What Does Amortization Mean?

Amortization involves the systematic reduction of an account balance, such as prepaid expenses and capitalized loan costs, over a specified time. Simply stated, amortization is the process of reducing an amount such as a loan balance for a mortgage or auto loan by making monthly payments. In accounting, amortization tables or amortization calculators are used as support for journal entries and reconciliations that involve annual amortization expense. Amortization factors into financial planning. However, metrics such as EBITDA – earnings before interest, taxes, depreciation and amortization – exclude amortization to get a true sense of operational profitability.

Amortization Expense Example

The cost of an intangible asset or non-physical assets, are amortized over a set number of periods. Examples of intangible assets include prepaid insurance, patents, trademarks and copyrights. Since insurance policies are typically written for an annual period, a premium payment can be amortized over a 12-month period. The prepaid is amortized equally over the 12-month term, so that the company can recognize the insurance coverage expense in the correct periods. The prepaid expense entry is often automated as part of the general ledger system and month-end-close process. If additional insurance coverage were added and a new premium paid, it could change how the prepaid insurance line item on the balance sheet is accounted for.

Entering An Amortization Journal Entry

When entering an amortization expense journal entry, it is important to remember that the balance sheet and income statement are impacted. The prepaid expense account or the value of the intangible asset on the balance sheet is credited or reduced, and the expense account is entered as a debit or increased. The journal entry should have support, such as an amortization table and listing of prepaid expenses attached to it, as support for the entry. Unsupported prepaid assets on the company’s balance sheet pose a risk to accountants and decision-makers alike.

Calculating Amortization Expense

Amortization expense is typically calculated using a schedule that illustrates a beginning balance, and a series of equal expenses, that reduce the beginning balance to zero. The amortization table can be relatively simple and is oftentimes created in Excel. Dividing the beginning balance by the number of amortization periods typically yields the amortization amount. General ledger accounting software can automate the calculation of amortization expense. Automated reconciliation applications may also have an amortization table functionality. The expense amounts are ultimately used as a tax deduction which decreases the tax liability for the entity.

Depreciation Vs. Amortization

Tangible fixed assets, such as property, plant and equipment, are recorded at cost and are depreciated over a specified useful life. Accumulated depreciation, which is the sum of all depreciation expenses recorded over the life of an asset, is displayed on the balance sheet. This methodology is only used for tangible assets, though. Intangible assets, such as prepaid rent, can be amortized but not depreciated. This is an important distinction that accountants must observe every month-end-close.

Risks Associated With Amortizing Prepaids

Prepaid expenses can be manipulated to conceal theft or fraud. For example, cash can be taken from a bank account, and a false prepaid asset can be created to conceal the theft. As such, amortization schedules should be reconciled against other supporting documents to ensure accurate amortization expense recognition. Internal control over amortization expense is important for all stakeholders in a business.

Amortization is important because it helps businesses recognize expenses in the appropriate accounting period. This has a myriad of benefits, including relevant financial reports that help investors, owners and other stakeholders make effective economic decisions.

Resources:
https://www.harpercollege.edu/academics/academic_support/tutoring/subjects/pdf/Depreciation%20CR.pdf