What is amortization?
Amortization is the recognition of an expense over an asset's useful life to account for the original cost of acquiring an asset. This aligns the cost of the asset with the revenue generated from the asset (the matching principle of account).
Amortization can also refer more broadly to the amortization of an expense or repayment of a loan; I cover debt amortization under Debt and depreciation under Capital Expenditures, and this focuses on amortization of intangible or other assets.
The primary cause of amortization is the acquisition of intangible assets. Unlike tangible assets, intangibles do not possess a physical form but still hold value for the company. The need to amortize these assets arises from the recognition that they contribute to revenue generation over multiple periods, and their value diminishes as they provide economic benefits to the company.
Types of Assets Typically Amortized
Common intangible assets subject to amortization include:
- Patents: Legal rights granted to inventors, providing exclusive rights to produce and sell their inventions for a certain period.
- Trademarks: Recognizable signs, designs, or expressions distinguishing products or services from those of others.
- Copyrights: Legal rights given to creators for their original works, including literary, musical, and artistic works.
- Software: Costs associated with developing or acquiring computer software for business use.
Additionally, Goodwill often arises from the acquisition of one company by another at a price above the fair value of its net tangible assets, but is technically no longer amortized but is subject to annual valuation (called impairment tests) to assess if the value has decreased and needs to be marked down.
Typical Amortization Periods
The amortization period for an intangible asset depends on its expected useful life, defined as the time that the asset is anticipated to contribute economic benefits to the company. This period can vary significantly based on the nature of the asset:
- Patents are typically amortized over their legal life, which can be up to 20 years in many jurisdictions.
- Software might be amortized over a shorter period, reflecting technological advancements and usage patterns, often between 3 to 5 years.
Amortization is a non-cash expense
Amortization appears as an expense in the other income and expense section on the Income Statement, reducing the company's net income for the period it is incurred. On the balance sheet, the carrying amount of the intangible asset is reduced by the accumulated amortization, mirroring the asset's declining value as it ages. Just like depreciation, since amortization is a non-cash expense, it is added back to net income in the cash flow from operations section of the statement of cash flows.
Amortization plays a critical role in understanding a company's operational performance and financial health. By spreading the cost of intangible assets over their useful lives, amortization provides a more accurate picture of how assets contribute to generating revenue and achieving long-term strategic goals.
How to use
The Standard Financial Model, Starter Financial Model, and Runway and Cash Forecasting Tool all share a core component in the Forecast sheet that handles the calculations of amortization based on the purchases of other assets defined in the model.
In the core revenue and expense section on the Forecast sheet, any line can be assigned as a purchase of other assets, and is then summed into the total new purchases of other assets for that period. The input that defines the period over which those assets are amortized is on Get Started, called Amortization, straight-line for N months. By default amortization is straight-line, and all assets in thie category use the same amortization period.
How it works
The amortization component in the models work exactly the same as depreciation, just replace "Capital Expenditures" and "Depreciation" with "Purchase (Disposal) of Other Assets" and "Amortization", respectively. The calculations mirror the capital expenditures and depreciation structure, and can be used in a similar fashion for any intangible or other assets that you want to amortize.